sou · GOB311d5 · 2001-01-01 00:00:00 — Kroszner, , (1997b), Markets: The Economics and Politics of Market Microstructure Reforms, pp. 86-110 in and , eds., The Debt Burden and Monetary Policy, : . Kroszner, , (1998a), Regulation: A Review of the Historical Evidence, , Summer: 48-58. Kroszner, , (1998b), The Political Ec onomy of Banking and Financial Regulatory Reform in Emerging Markets, Research in 10: 33-51. Kroszner, , (1999), Is It Better to Forgive than to Receive? Repudiation of the Gold Indexation in during the Great Depression, working paper, , , April. Kroszner, , Less is in the Financial Architecture, in W. C. and G. G. , editors, The : for Reform, forthcoming. Kroszner, and Raghuram G. , (1994), Is the Glass- Steagall Act Justified? A Study of the U.S. Experience with before 1933, 84, : 810-32. Kroszner, and Raghuram G. , (1997), Organization Structure and Credibility: Evidence from Activities before the Glass-Steagall Act, 29, : 475-516. 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La Porta, , , , and , (1998), and Finance, 106, : 1113-55. La Porta, , , and , (1999), Corporate Ownership around the World, , April: forthcoming. McCubbins, , , and , (1988), Structure and Process, Politics and Policy: Administrative Arrangements and the Political Control of Agencies, 78: 431-82. McGuire, and Mancur , (1996), The Ec onomics of Autocracy and Majority Rule, , , , (1998), Political Structure and Corporate Governance: Some Points of Contrast between the and , , 51-78. Mondino, , , and , (1992), Recurrent High Inflation and Stab ilization: A Dynamic Game, working paper. SOU 2000:11 Politically Independent? Niskanen, , (1971), Bureaucracy and Representative Government, : Aldine-Atherton. North, , (1990), A Transactions Cost Theory of Politics, 2: 355-67. Noll, , (1989), Comment on Peltzman, Brookings Papers: Microeconomics, 48-58. , Mancur, (1965), The Logic of Collective Action, , MA: . , Mancur, (1982), The and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities, : . Peltzman, , (1976), Toward a of Regulation, 19; 1, April: 109-148. Peltzman, , (1984), Constituent Interest and C ongressional Voting, 27: 181-210. Peltzman, , (1989), The Ec onomic Theory of Regulation after a Decade of Deregulation, Brookings Papers: Microeconomics: 1-41. Poole, and , (1993), The Enduring Nineteenth-Century Battle for Economic Regulation: The Interstate Commerce Act Revisited, 36, October: 837-60. Poole, and , (1996), Are Legislators Ideologues or the Agents of Constituents?, 40: 707-717. 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Positive Theories of , : . , ., (1971), The Theory of Ec onomic Regulation, Science 2; 1, Spring: 3-21. , ., (1988), Studies in the Political Economy, : . Umlauf, S., (1993), An Empirical Study of the Mexican Treasury , 33; 3: 313-40. Securities and Exchange Commission, and of System, Joint Report on the Market, : Government Printing Office, January (1992). Weingast, . and . , (1988), ; or, Why Legislatures, like Firms, Are Not Organized as Markets, 96, February: 132-63. , , (1983), The Regulation and Reform of the System, 1900-1929. , , (1994), ed. The Political Economy of Policy Reform, : . , , (1996), The Politics and Ec onomics of Redistribution and Efficiency, In The Mechanisms of Governance, : . Wittman, ., (1995), The Myth of Democratic Failure. What Is Optimal Financial Regulation? . Santomero** Supplement number 26 to the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. Views, suggestions, and opinions expressed in this study represent the personal views of the authors and not necessarily those of the Government Inquiry on the International Competitiveness of the Swedish Financial Sector. *of ; Professor of Finance, , , , , PA 19104, . **Professor of Finance, , , , , PA 19104, . Volym D:164 Supplement 26 Kort sammanfattning (in Swedish) ..................................................... Rationales for financial regulation ............................................. Guarding against systemic risk............................................... Achieving other social objectives............................................ Why banks have been especially important ............................... regulation and supervision: the financial Optimal regulation in the static case: pricing risk to counter Risk-rated deposit insurance premiums................................... Prompt corrective action and least cost resolution................... Narrow bank proposals .......................................................... Looking beyond the static view: Banks have become less Optimal regulation in the transition: some simple What Is Optimal Financial Regulation? Kort sammanfattning (in Swedish) Det grundläggande målet för reglering av finansiell verksamhet är att förebygga s.k. systemrisker, dvs. risken att en störning fortplantar sig på ett sätt som de enskilda aktörerna inte kan hantera och som kan ge stora samhällsekonomiska skadeverkningar. Denna typ av risk hänför sig i första hand till bankerna som dels har en sammansättning av sin balansräkning som gör dem särskilt exponerade för denna typ av risk, dels av tradition utgjort den dominerande delen av det finansiella systemet. De skyddsnät som etablerats genom olika former av reglering har varit framgångsrika i så måtto att svåra systemkriser kunnat undvikas. skapar dock regleringar även problem, bl.a. när det gäller aktörernas incitament ifråga om rikstagande och riskhantering. Dessa problem kan visserligen i viss utsträckning hanteras på olika sätt, men dilemmat består. Den teknologiska och marknadsmässiga utvecklingen, främst i men även i andra länder, gör dock både att bankerna får en mindre dominerande roll i det finansiella systemet, och att bankerna får en annorlunda ekonomisk och finansiell struktur som gör dem mindre avvikande från andra företag och mindre exponerade för systemrisk. Ur samhällssynpunkt är detta en positiv utveckling som bör underlättas, exempelvis genom anpassning av regelverk och tillsyn, eftersom detta innebär att den speciella regleringen av banksystemet, med de negativa bieffekter detta har, då successivt kan avvecklas. Volym D:166 Supplement 26 The financial system is regulated to achieve a wide variety of purposes. However, the objective that distinguishes financial regulation from other kinds of regulation is that of safeguarding the economy against systemic risk. Concerns regarding systemic risk focus largely on banks, because they traditionally have been viewed as occupying a special role in the economy. The safety nets that have been rigged to protect banks from systemic risk have succeeded in preventing banking panics. However, this success has come at the cost of distorting incentives for risk taking. Regulators have a variety of options to correct this distortion, but none can be relied upon to produce an optimal solution. Technological and conceptual advances may be ameliorating the problem, nonetheless. Banks are becoming less special. As is evident from the data reported here, the US is leading the way. The trends are apparent in other industrial countries as well. Once banks have lost their special status, financial safety nets may be dismantled thus ending the distortions they create. Ultimately, regulation for purposes may be completely unnecessary. The optimal regulation for safety and soundness purposes may be no regulation at all. The challenge facing regulators is to facilitate these advances and hasten the end of the special status of banks. Here, we offer several simple prescriptions to improve financial regulation. 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. Second, regulators should resist the temptation to re-regulate or promulgate regulations that will forestall the inevitable financial restructuring that is part of this change process. 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. 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. What Is Optimal Financial Regulation? 1 Introduction*** The financial system is regulated to achieve a wide variety of purposes. However, the objective that distinguishes financial regulation from other kinds of regulation is that of safeguarding the economy against systemic risk. Concerns regarding systemic risk focus largely on banks, which traditionally have been considered to have a special role in the economy. The safety nets that have been rigged to protect banks from systemic risk have succeeded in preventing banking panics, but at the cost of distorting incentives for risk taking. Regulators have a variety of options to correct this distortion, but none can be relied upon to produce an optimal solution. Technological and conceptual advances may be ameliorating the problem, nonetheless. Banks are becoming less special. The US is leading the way, but the trends are apparent in other industrial countries as well. The challenge facing regulators is to facilitate these advances and hasten the end of the special status of banks. Once banks have lost their special status, financial safety nets may be dismantled thus ending the distortions they create. Ultimately, regulation for purposes may be completely unnecessary. The optimal regulation for safety and soundness purposes may be no regulation at all. *** An earlier version of this paper was presented at the symposium on the International Competitiveness of the , organized by 25, 1999. Volym D:168 Supplement 26 2 Rationales for financial regulation A well-functioning financial system makes a critical contribution to economic performance by facilitating transactions, mobilizing savings and allocating capital across time and space. Financial institutions provide payment services and a variety of financial products that enable the corporate sector and households to cope with economic uncertainties by hedging, pooling, sharing and pricing risks. A stable, efficient financial sector reduces the cost and risk of investment and of producing and trading goods and services.1 Financial markets also provide a crucial source of information that helps coordinate decentralized decisions throughout the economy. Rates of return in financial markets guide households in allocating income between consumption and savings, and in allocating their stock of wealth. Firms rely on financial market prices to inform their choices among investment projects and to determine how such projects should be financed.2 In view of these critical contributions to economic performance it is not surprising that the health of the financial sector is a matter of public policy concern and that nearly all national governments have chosen to regulate the financial sector. (1990) is undoubtedly correct when he argues that the overall objective of regulation of the financial sector should be to ensure that the system functions efficiently in helping to deploy, transfer and allocate resources across time and space under conditions of uncertainty. However, actual financial regulation attempts to accomplish several objectives beyond facilitating the efficient allocation of resources. In fact, at least four broad rationales for financial regulation may be identified: safeguarding the financial system against systemic risk, protecting consumers from opportunistic behavior, enhancing the efficiency of the financial system, and achieving a broad range of social objectives from increasing home ownership to combating organized crime. 1See Herring and Santomero (1991) for a detailed discussion of the role of the financial sector in a developed economy. For a more recent reference, see and Santomero (1997). 2This is the role emphasized by (1989). See LIewellyn (1999) for discussion of the economic rationale for regulation. What Is Optimal Financial Regulation? 2.1Guarding against systemic risk Safeguarding financial markets and institutions from shocks that might pose a systemic risk is the prime objective of financial regulation. Systemic risk may be defined as the risk of a sudden, unanticipated event that would damage the financial system to such an extent that economic activity in the wider economy would suffer. Such shocks may originate inside or outside the financial sector and may include the sudden failure of a major participant in the financial system, a technological breakdown at a critical stage of settlements or payments systems, or a political shock such as an invasion or the imposition of exchange controls in an important financial center. Such events can disrupt the normal functioning of financial markets and institutions by destroying the mutual trust that lubricates most financial transactions. Regulatory measures and regulatory objectives Antitrust enforcement/ ompetition policy Conduct of business rules Conflict of interest rules Fit and proper entry tests Interest rate ceilings on deposits Interest rate ceilings on loans Investment requirements Liquidity requirements Reporting requirements for large transactions Restrictions on geographic reach Restrictions on services and product lines Adapted from Herring and Litan (1995). As an examination of the Systemic Risk column of Figure 1 indicates, a substantial number of regulatory measures have been justified on grounds that they help safeguard the financial system from systemic risk. However, research has shown that a number of these measures, such as restrictions on product lines, are ineffectual at best in safeguarding Volym D:170 Supplement 26 against systemic risk and may weaken regulated institutions by preventing them from meeting the changing needs of their . Some measures, such as interest rate ceilings on deposits that were intended to prevent excessive competition, may actually exacerbate vulnerability to systemic risk. For example, when interest rate ceilings are binding, depositors will have an incentive to shift from bank deposits to assets yielding a market rate of return thus inducing funding problems for banks. It should be noted also that some regulatory measures work at cross- purposes. For example, geographic restrictions on banking, intended to protect the access to credit of local firms and households, may increase exposure to systemic risk by impeding diversification of regulated institutions and increasing their vulnerability to a local shock. Similarly, the fit and proper tests one might want to impose for safety and soundness reasons may pose entry barriers that are too high to achieve the efficiency gains from competition. We will examine systemic risk and measures to counter systemic risk in greater detail in sections 3 and 4. The second fundamental rationale for financial regulation is the protection of consumers against excessive prices or opportunistic behavior by providers of financial services or participants in financial markets. (See the Consumer Protection column of Figure 1.) Antitrust enforcement is the most obvious policy tool to counter excessive prices. Competition policy is motivated not only by the concern to protect consumers from monopolistic pricing, but also by the aim of harnessing market forces to enhance the efficiency of the allocation within the financial sector and between the financial sector and the rest of the economy.3 The was the first nation to adopt antitrust policy, which, of course, is concerned with monopolistic pricing in all markets not just financial markets. the past decade Commission has increasingly taken a more activist role in promoting competition. Last year significant attention was focused on substantial price variations within various categories of financial products offered within Union.4 Although substantial gains have yet to be 3See section 2.3 for a further discussion of this point. 4See European Commission, 1998. SOU 2000:11 What Is Optimal Financial Regulation? realized, Unions goal of forming a single market in financial services is aimed at increasing competition and lowering prices to users of financial services. Consumers of financial services – particularly unsophisticated consumers – find it very difficult to evaluate the quality of financial information and services provided to them. In part this is because payment for many financial transactions must often be made in the current period in exchange for benefits that are promised far in the future. But even after the decision is made and financial results are realized, it is difficult to determine whether an unfavorable outcome was the result of bad luck, even though good advice was competently and honestly rendered, or the result of incompetence or dishonesty. face a problem of asymmetric information in evaluating financial services. Consequently they are vulnerable to (adverse selection), the possibility that a customer will choose an incompetent or dishonest firm for investment or agent for execution of a transaction. They are also vulnerable to (moral hazard), the possibility that firms or agents will put their own interests or those of another customer above those of the customer or even engage in fraud. In short, unsophisticated consumers are vulnerable to incompetence, negligence and fraud. In order to ease these asymmetric information problems, regulators often establish fit and proper tests for financial firms to affirm their quality (ex ante). And (ex post), it is hoped that strict enforcement of conduct of business rules with civil and criminal sanctions will deter firms from exploiting asymmetric information vis-à-vis . Strict enforcement of conduct of business rules also provides firms with incentives to adopt administrative procedures that ensure consumers are competently and honestly served and that employees will behave in a way that upholds the firms reputation. Conflict of interest rules and customer suitability requirements serve a similar function. The provision of insurance is another response to the asymmetric information problem faced by unsophisticated consumers. One of the rationales for deposit insurance is to protect unsophisticated depositors of modest means who would find it excessively costly to monitor their bank. This is articulated particularly clearly in the Directive of Union. Other kinds of financial contracts are also insured for the protection of unsophisticated consumers. In the , for example, the , a government-sponsored entity insures pension coverage up to ,000 a year for each worker. Disclosure requirements also help ameliorate the asymmetric information problem. Investors are often at an informational disadvantage with respect to issuers of securities. Volym D:172 Supplement 26 investors have the leverage to compel an issuer to disclose relevant data and the expertise to evaluate such data, unsophisticated consumers lack both the leverage and the expertise. For this reason governments have found it useful to standardize accounting practices, require the regular disclosure of data relevant to a firms financial and encourage the development of rating agencies, which enable even small investors to take advantage of economies of scale in gathering and analyzing data. Disclosure concerns also extend to the way in which information is made available to the public. The has prohibited insider trading to ensure that corporate officials and owners with better information about the financial of their companies cannot profit at the expense of non-insiders. Until recently, insider trading was not illegal in nor effectively policed in . But with the adoption of the Directive of Union and the disclosure of significant insider trading in in the early 1990s this has changed (Herring and Litan 1995). Reserve requirements, capital requirements and liquidity requirements designed to ensure that a financial services firm will be able to honor its liabilities to its , have a consumer protection (and microprudential) rationale as well as a macroprudential rationale to safeguard the system against systemic risk. In effect, regulators serve a monitoring function on behalf of unsophisticated of modest means. Competition policy and anti-trust enforcement are the key tools for enhancing the efficiency of the financial system as can be seen in the Efficiency Enhancement column of Figure 1. In addition to prosecuting price-fixing arrangements, the main emphasis here is to minimize barriers to entry into the financial services industry. In this light, fit and proper tests established for consumer protection purposes appear to be anti-competitive and unnecessary. After all, the expectation of repetitive transactions with a client will give firms reason to be concerned with their reputations. This will reduce the risks of adverse selection and moral hazard to , except when the expected gain from taking advantage of a client is very large or when the interests of a firms employees differ from those of the owners. However, primary reliance on a firms concern for its reputation is not an entirely satisfactory solution to the problem of asymmetric information. Since it takes time to build a reputation for honest dealing, What Is Optimal Financial Regulation? primary reliance on reputation to establish the quality of financial firms tends to restrict entry. This may result in higher transactions costs than would prevail in a perfectly competitive market. For this reason establishing fit and proper tests that enable new entrants to affirm their quality ex ante may ease entry and enhance competition, although if entry hurdles are set too high, they will surely compromise efficiency objectives.