Mr. Meyer discusses issues and trends in bank regulatory policy and financial modernization in the United States  (Central Bank Articles and Speeches, 9 Jun 98)
Central bank: fed | Type: speech | Date: 1998-06-09

Mr. Meyer discusses issues and trends in bank regulatory policy and financia modernization in the United States Remarks by Laurence H.

Meyer, a member of the Board of Governors of the US Federal Reserve System, at the Bank Administration Institute, Finan Accounting Management Conference held in Washington, DC on 9/6/98.It is a pleasure to be here today, and I thank the Bank Administration Inst inviting me to be a part of your discussions.When people think of the Federal Reserve, I am pretty sure that most Ameri think of monetary policy, interest rates, international finance, and the Fed's macr responsibilities in all of these areas.

And, of course, macroeconomics lies at the core central bank does.

However, as everyone at this conference appreciates, another major fun the Federal Reserve is the supervision and regulation of banks and bank holding companies. like to use my time this afternoon to discuss some key aspects of this side of the Fed's acI will begin by outlining, very briefly, some of the key trends affecting th and financial sector.

I will then focus on what I see as the most important challenges trends pose for bank supervisors, and suggest some directions that I believe we should cons thinking about how bank supervision should evolve over time.

Lastly, I will discuss legislative efforts to modernize our banking system.

## Key Trends Challenging Bank SupervisorsSurely the most profound force transforming the financial, and for that matte sectors of our economy, is the rapid growth of computer and telecommunications technolo finance, a critical and complementary force is the development of intellectual 'technolo enable financial engineers to separate risk into its various components, and price each co an economically rational way.Implementation

of financial engineering strategies typically requires ma amounts of cheap data processing; and the cheap data processing would not be useful with formulas required to compute prices.

The combination of the two has led to a virtual explos number and types of financial instruments.

Such products have lowered the cost and broade scope of financial services, making it possible for borrowers and lenders to transact d each other, for a wide range of financial products to be tailored for very specific purp financial risk to be managed in ever more sophisticated ways.Financial innovation has been the driving force behind a second major tre banking -- the blurring of distinctions among what were, traditionally, very distinct financial firms.

One of the first such innovations, with which we are all now very fam money market mutual funds.

In the 1980s, banks began to challenge whether the Glass-Steaga prohibited combinations of commercial and investment banking.

Today, both the regulators a courts agree that Glass-Steagall does not imply a total prohibition.

More recently, separations of banking and insurance sales have also begun to fall, with support from the and the courts.A major result of the continued blurring of distinctions among commercial ban investment banking, and insurance is a tremendous increase in competition for many fi services.

Greatly intensified competition has also led to increasing pressure for revision the banking laws and regulations that, despite some successful efforts at relaxation continue to exert outdated and costly restraints on the banking and financial system.Indeed, despite its often frustratingly slow pace, there seems little do deregulation has been a major force for change in the banking and financial services indus decades ago we still had Regulation Q, the Glass-Steagall Act was widely viewed as requ virtual prohibition of combinations of commercial and investment banking, and interstate and branching, let alone combinations of banking and insurance, were barely fantasies eve state level.The fourth major force transforming the banking landscape is the globalizati only of banking and financial markets, but also of the real economy.

The interact developments in both the financial and real economies have expanded cross-border asset ho trading, and credit flows.

In response, financial intermediaries, including banks and secu have increased their cross-border operations.

Once again, a critical result of this rapid been a substantial increase in competition both at home and abroad.The final significant trend I will highlight is the on-going consolidation o banking industry.

I think that it is fair to say that the American banking system is cur midst of the most significant consolidation in its history.

In 1980 there were about 14,4 the U.S. organized into about 12,300 banking organizations.

By the end of 1997, the nu banks had fallen to just under 9,100, and the number of banking organizations to not qui This 42 percent decline in the number of banking organizations was due in part, but only the large number of bank failures in the late 1980s and early 1990s.

A more important fa mergers among healthy banks.

Since the early 1980s, it has not been unusual to see 400 mergers among healthy banks each year.While mergers have occurred, and continue to occur, among banks of all siz would emphasize three aspects of the current bank merger movement.

First is the high inci 'megamergers', or mergers among very large banking organizations.

Several mergers of the la years have been either the largest at the time, or among the largest bank mergers in U.

And, of course, that trend continues.Second, despite all of the merger activity, a large number of medium to small remain in the United States.

Moreover, by most measures of performance these small banks ar than a match for their larger brethren for many bank products and services.

When a megame announced it is not uncommon to read in the press how small banks in the affected mark looking to take advantage of the business opportunities created thereby.

Research seems t their optimism.Lastly, while the overall number of banking organizations has fallen since 198 does not mean that new, or de novo, entry has not occurred.

From 1980 through 1997 some new banks were formed in the United States.In large part because of the continued viability of smaller banks, while the concentration of banking assets has increased substantially since 1980, measures of loc banking concentration have remained essentially unchanged.

Indeed, the stability of loca concentration in the face of such a large consolidation of the banking industry is remar bodes well for the competitive vitality of local banking markets.While the reasons for bank mergers are varied, the bottom line is that the States is well on its way to developing a truly national banking structure for the firs history.

We are not quite there yet, but I do not think it will take too many more years.

## Future Directions in Bank Supervision

## What do all of these changes mean for how we supervise and regulate banks?

## Analysis of CompetitionClearly,

as the banking industry consolidates we need to maintain compet markets.

Competitive markets are our best assurance that consumers receive the highest products at the lowest possible prices.

As I discussed earlier, there are many reasons to in recent years competition has increased greatly in markets for a large number of financi and services.

This is true for many products purchased in local, regional and national However, in some cases we still observe potential competitive problems with a proposed merger.

Fortunately, the antitrust laws, as written into the banking statutes, give us maintain competition in such situations.

These laws require that the Board approve on mergers that are not expected to substantially harm competition.Over the past year or so, quite a few applicants have pushed very hard at the frontier for approving merger applications.

In response, the Board has occasionally felt c remind applicants, especially those proposing a merger that would affect a large number markets, that substantial changes in market concentrations will receive careful review. when mergers would exceed the screening guidelines, 'mitigating' factors must be prese mitigating factors I mean conditions that tend to create a more competitive market than is by market concentration alone.

The greater the deviation from the screening guidelines, powerful and convincing the mitigating factors must be.I have personally been particularly concerned with cases where a large numb local markets are affected.

In such cases, even if the adverse effect is fairly small in local markets, it seems to me that the cumulative, or total, adverse effect might be signi a large number of markets are affected adversely, I believe that we should be especially assure ourselves that there are substantial mitigating factors.

In addition, when a merger a large change in concentration in a market that is, or becomes, highly concentrated, I th to give special attention to the impact on competition.

## Assessing Safety and SoundnessTechnological

change, financial innovation, the acquisition of new powers banking organizations, the increasing geographic scope of banks, and the globalization of markets all challenge our ability to examine and assess the safety and soundness of i banking firms.

One way that examiners are adapting to this changed world is to focus much attention on the information and risk management systems of banks.

The key question they How effectively are these systems measuring and controlling an institution's rapidly chan profile?

The emphasis on risk management is most critical at our largest, most sophistic most internationally active banks.

Many of these banks use advanced economic and stat models to evaluate their market and credit risks.

These models are used for a variety of including allocating capital on a risk adjusted basis and pricing loans and credit guaranteThe development by some banks of increasingly accurate models for measurin managing, and pricing risk has called into question the continuing usefulness of on foundations of bank supervision -- the so-called risk-based capital standards, or the Ba The Basle Accord capital standards were adopted in 1988 by most of the world's industr nations in an effort to encourage stronger capital at riskier banks, to include off-b exposures in the assessment of capital adequacy, and to establish more consistent capital across nations.

The Accord was a major advance in 1988, and has proved to be very usefuthen.

But in recent years calls for reform have begun to grow.

I will outline briefly on problems we are currently facing with the Basle Accord.The Basle Accord capital standards divide bank on- and off-balance-sheet asset four risk buckets, and then apply a different capital weight to each bucket.

These weigh roughly with the riskiness of the assets in a given bucket.

However, the relationship Perhaps most troublesome, the same risk weight is applied to all loans.

Thus, for example, a very risky 'junk bond' company gets the same weight as a loan to a 'triple A' rated firm.This aspect of the Accord clearly gives banks an incentive to find ways to av regulatory capital standard for loans that their internal models say need less capital th by the Basle Accord.

Conversely, banks should want to keep loans which their models say more capital than does the Basle standard.

And, guess what, banks have been doing just t so-called 'regulatory arbitrage' may not be all bad, but it surely causes some serious p well.

For one thing, it makes reported capital ratios -- a key measure of bank soundnes supervisors and investors -- less meaningful for government supervisors and private analyst ways around this problem is a high priority at the Federal Reserve.The arbitraging of regulatory capital requirements is but one of a host of conflicts between banks and bank supervisory rules and regulations.

Indeed, one can view the long history of bank supervision and regulation as something of a contest between su who want to deter excessive risk taking and banks who seek ways around sometimes ineffici just plain uneconomic, regulations.

This long history leads me to seek supervisory strategi in the economist's jargon, incentive compatible.

By incentive compatible, I mean supe policies and procedures that give banks strong internal incentives to manage their risks pr minimize the exploitation of moral hazard.

Put differently, we need to design strate encourage banks, in their own self-interest, to work with us, not against us.When designing supervisory policy, we should always remember that the first li defense against excessive risk-taking by banks is the market itself.

Market discipline c often is, highly effective at deterring excessive risk.

Indeed, a primary goal of many regulatory reforms implemented in the wake of the banking and thrift crises of the 1980s 1990s was either to increase market discipline or to make supervisors behave more like th would behave.

Market discipline was increased, for example, by raising capital standards mandating greater public disclosure by a bank of its financial condition.

Prompt correct rules that require supervisors to impose increasingly severe penalties on a bank as it condition deteriorates, and the adoption of risk-based deposit insurance premiums are exa encouraging supervisors to act like the market.The reforms of the early 1990s were a good start.

But I believe that there may more that we can do.

Such comments may sound out of place today.

Times are good, and al everyone seems quite satisfied with the current deposit insurance system.

But good times precisely when we should develop ideas for an even more effective system.

The crucible of a not always the best time to think up reforms -- witness the error we made in passing t Steagall Act, an error we have yet to correct after 65 years!

Indeed, it is in part for t that the Board continues to urge Congress to pass financial modernization legislation. spirit of being forward looking, let me attempt to give you the flavor of one idea that considering.It may be possible to increase market discipline by requiring large, intern active banks to issue a minimum amount of certain types of subordinated debt to the pub appealing aspect of this approach is that subordinated debt holders, so long as they ar'insiders,' face only downside risk, and thus their risk preferences are very close to FDIC.

Subordinated debt holders would therefore be expected to impose market discipline bank that is quite consistent with what bank supervisors are trying to do, including e banks to disclose more information about their financial condition.

Observed risk prem subordinated debt could perhaps be used to help the FDIC set more accurate risk-based insurance premiums, and such debt would provide an extra cushion of protection for taxpay additional benefit of having subordinated debt traded on the open market is that price m would provide a clear signal of the market's evaluation of the bank's financial condition t it were not used to help price deposit insurance, could serve as an early warning aid to suSubordinated debt is not, however, without its problems.

For example, the preferences of such creditors are aligned with those of the FDIC only when the bank is solvent.

At or near insolvency, subordinated debt holders may be willing to 'bet the bank to increase the chances that they will not suffer a loss.

The fact that the bank closure d in the supervisor's hands is another complicating factor.

In addition, it is unclear just liquid a market in bank subordinated debt would be, although limiting any requirements largest banks would ease this concern.

For example, at the end of last year only one-half banks with less than $50 million in assets issued subordinated debt, but 83 percent of total assets of $10 billion or more did so.

However, it appears that much of exist subordinated debt is held by the bank's parent holding company, not independent third parti the question of how deep and liquid a market might evolve remains.

For these and other rea operationally feasible program for mandatory subordinated debt would require a consid amount of careful thought.

Still, in my judgment it is thought that might prove very worthw

## The Need For Financial ModernizationTechnology and globalization are changing markets all over the world, but pe none have been more affected than the financial markets.

Yet in the United States much of framework has essentially not changed since the 1930s.

The resultant pressure on f institutions to be able to compete has thus been reflected in the search for loopholes and regulatory authorities to find ways within their charter to permit new activities.

The p only inefficient, but creates new inequities, institutions that may be producing unintende the misallocation of resources.

That is why my colleagues and I are such strong supporter 10, The Financial Modernization Act of 1998, which the House passed last month and the S Banking Committee will be discussing next week.This bill brings our financial institutions into the 21st century in a frame minimizes risks and inequities.

The task it sets for itself is not easy.

Each set of institutions -- and their regulators -- have special privileges and advantages that t maintain and limits and restraints that they wish to shed.

Balancing these realities provisions in the bill that no one -- including me -- can say that they like complete balancing in H.R. 10 is, I think, the best that is possible; indeed, in many respects it that most adjustments to address the concerns of one set of institutions would probably el support of another set of institutions.

What is critical, it seems to me, is that the bill fine balancing job, but it is in the public interest, something that I am sorry to sa frequently we lose sight of.

Let me share with you the specific reasons why I think this i deserves support.First and foremost is that the bill would finally let financial institutions g other's businesses, and thus widen the scope and range over which institutions can compet public's business.

Mind you, this is not a statement that says financial supermarkets a institutions will be better or more successful than specialized and/or smaller institutibenefit is that the public, not regulators, will decide which will prosper as competitors efforts to serve the consumer.That is the bottom line.

It's the reason why there should be financial modern But the structure that the bill establishes is consistent both with efficient resource allo minimizing risk to the stability of the economy and the taxpayer.

Let's take a closer l structure.The most critical element is that H.R. 10 would permit banks to conduct in the subsidiaries (so-called operating subsidiaries or 'op subs') only the same activities th already conduct in the bank and financial agency activities, which by their nature requi funding and create minimal risk.

These limitations, it seems to me, are crucial for seve Banks have a lower cost of funds than other financial entities because of the safety net we give the collection of deposit insurance, access to the discount window, and acces payments system.

This subsidy is provided by the government in order to buy systemic stabi it has a cost: increased risk taking by banks, reduced market discipline, and consequentl for more onerous bank supervision in order to balance the resultant moral hazard.

The last should want is to extend that subsidy over a wider range of activities, which is, I bel what would happen if bank op subs could engage in wider nonbank financial activities.

N would that increase the moral hazard -- and the need for bank-like supervision -- but it unbalance the competitive playing field between bank subs and independent firms engaging same business, a strange result for legislation whose ultimate purpose is to increase the for financial services.The subsidy that is so integral to the op sub would surely induce banks and financial institutions to organize in a form that would maximize their use of that subsi stockholders would have every reason to be critical of management that did not avail its opportunity to raise low cost funds.

The profits of bank subsidiaries would surely benefi parent since GAAP accounting, economic and legal reality, and common sense all cal consolidation.

But losses, too, would consolidate into the bank parent and such losses directly on the safety net, and ultimately the taxpayer.

These safety and soundness and risks ultimately would bring with them the need to regulate op subs the way banks are r creating inefficiencies and reductions in innovation, let alone conflicts with functional rThe legislation I support would require that organizations that conduct both and other financial businesses organize in a holding company form where the bank and th activities are both subs of the holding company.

Profits and losses of the business lines holding company and thus do not directly benefit nor endanger the bank, the safety net taxpayer.

The safety net subsidy is not directly available to the holding company affi competition is thus more balanced.

Moreover, traditional regulators like the SEC and insurance commissioners still regulate the entities engaged in nonbank activities as if independent firms.

Functional regulation is desirable not only for competitive equity, political necessity and a practical reality in the process of balancing that is requ financial regulation.

In principle, functional regulation could also be applied to op s safety net, I submit, would soon create regulatory conflict with that structure.Importantly, the bill passed by the House would prohibit commercial affiliatio banks.

There is no doubt that it is becoming increasingly difficult to draw a bright line financial services from nonfinancial businesses; it will only become more difficult to do truth is that we are not sure enough of the implications of combining banking and comm potential conflicts of interest, concentration of power, and safety net and stability c move forward in this area.

Better, I think, to digest financial reform before moving inwill be very difficult to reverse.

The bill, by the way, would shut down new unitary thri affiliate with non-financial firms, but grandfathers the rights of the over 700 existing holding companies to acquire or be acquired by commercial enterprises.

I would hope the would instead freeze such activities in place until the banking and commerce issue is directly; the fact that the House did not simply reinforces my point on how hard it is to powers once gained.Finally, I support H.R. 10 because the holding company framework would keep t Federal Reserve -- the central bank of the United States -- as the umbrella supervisor.

I the Fed has an important role to play in banking supervision in order to carry out its re for monetary policy, economic stabilization, and crisis management.

I cannot grasp how w possibly understand what is happening in banking markets, what innovations are occurring a implications, and the nature and quality of the risk exposures and controls so critica management and policy formulation without the hands-on practical exposure that comes supervision.

An umbrella supervisor is needed for complex organizations in order to assur entire organization and its policies and controls are well managed and consistent with stability.

At least for the large organizations, I believe that supervisor should be the F so that we can play our role as a central bank and international crisis manager.

Many p surprised to hear that the Fed directly supervises only 5 of the largest 25 banks -- the s Our window into banking is through our umbrella supervision of bank holding companies.Unfortunately, but understandably, the view that the Fed wants new activities a bank holding company is often construed as a 'turf' issue.

I believe that there are tw arguments.

I would prefer the holding company -- for reasons I have discussed -- even i were not the umbrella supervisor.

But I also think that we have to be involved in bank sup again for the reasons I have discussed.

Who should be involved in what activities, and wh supervise the resultant organization and its component parts are genuine and important pol that should be debated and decided by the Congress.

To simply dismiss them as turf issue the point, I think, and chokes off that debate.

## ConclusionIn conclusion, I hope that my remarks have helped you to better understand the affecting our banking and financial system.

Equally important, I hope that I have given y feel for the challenges these forces have created for bank supervision, how we are meet challenges today, and how we may deal with them in the future.

Even more importantly, I hop have convinced you to support enthusiastically H.R. 10!

In all seriousness, it really is modernized our financial system and got on with the business of serving consumers and main a healthy, stable, and competitive banking system.