Mr. Meyer looks at issues in financial modernization in the United States
Remarks by Mr. Laurence H. Meyer, a member of the Board of Governors of the US Federal Reserve
System, at the seventh annual Conference on Financial Structure in Annandale-on-Hudson, New
York, on 10/4/97.
It is my pleasure to take part in what has become an important annual meeting on
financial policy issues. It is my job to get you warmed up for a reception and dinner. Our hosts have a
curious view that a discussion of financial modernization will whet your appetite for food. Maybe so,
but it will almost surely increase your thirst.
It seems that people have been talking about financial modernization for a long time.
Indeed, in the short-run it is easy to become discouraged about how often we talk, but how rarely we
do anything, about financial modernization. However, if we step back and look over the last twenty
years, it seems to me remarkable both how much progress has been achieved and how much the
concerns of financial modernization have changed. Two decades ago we still had Regulation Q, the
Glass-Steagall Act was widely viewed as requiring a virtual prohibition of combinations of
commercial and investment banking, interstate banking and branching were barely fantasies even at
the state level, and combinations of banking and insurance were off most people's radar screens.
Today, many of the issues of 20 years ago have, blessedly, been resolved. But some remain, and new
ones have inevitably appeared. The contemporary concerns of financial modernization include repeal
of Glass-Steagall, expanded insurance activities for banking firms, the entry of insurance and
securities firms into banking, the possibility of unlimited mixing of banking and commerce, and
ongoing technological changes and financial innovations.
Tonight I would like to address some aspects of these concerns. I will suggest to you
that while financial modernization is still, as it was twenty years ago, a necessity, it is also the case
that in an uncertain world characterized by rapid change caution is not a dirty word.
I will begin with what for me is the easiest topic: banking and commerce.
The separation of banking and commerce has a long history in English-speaking
countries. Indeed, the policy can be traced back to the founding of the Bank of England in 1694. It
appears that commercial firms were concerned that the Bank's monetary powers would give it a
competitive advantage in mercantile activities if there were no separation of banking and commerce.
The young American state governments adopted, at least in principle, this separation of banking and
commerce.
However, from the beginning the separation of banking and commerce was hardly
complete in the U.S. banking system. State governments often saw the granting of bank charters as a
way of encouraging capital intensive development projects. As a result, pre-Civil War banks were
sometimes engaged in such activities as canal building, railroad construction, and even the
development of public water systems.
Thus, from early on the mixing of banking and commerce was a gray area in the
United States. This tradition continues to this day. For example, the same individual can own a
controlling share of both banking and commercial firms. Perhaps of more interest, a bank holding
company may acquire up to 5 percent of the voting shares of any commercial enterprise, as long as
the investment does not represent a controlling interest. In addition, the Board has permitted passive
investments in commercial firms of up to 25 percent of nonvoting shares, and an investment can be as
high as 49 percent if it is made through a small business investment company. Bank holding
companies can own 100 percent of the equity of a small business investment company.
We could all continue to give many examples, including the ownership of unitary
thrifts and specialized, and not-so-specialized, finance companies by commercial firms. Indeed, some
observers use these examples to argue that since the United States already has so much mixing of
banking and commerce, why not go all the way? In my view, such arguments exaggerate the reality.
Despite all the gray areas, I think it is fair to say that to a very substantial extent banking and
commerce are essentially separate activities in the United States. Thus, we need to think carefully
about whether we want to go even further down the road of combining banking with nonfinancial
activities.
Advocates of unrestricted mixing of banking and commerce make at least four
arguments: (1) both banking and commercial firms could more easily diversify their risks, (2) a
closely related argument is that such combinations would provide opportunities for synergies in
cross-selling, (3) combining banking and commerce could lead to more capital in the banking
industry, and (4) mixing banking and commerce would help to solve certain asymmetric information
and corporate control problems associated with commercial lending. Time does not permit me to
address each of these in detail. Suffice it to say that I find each of them wanting. I can find very little,
if any, in our experience as a nation that gives me real confidence about the benefits of combining
banking and commerce. And I can find no empirical support for any benefits for combining banking
and commerce based on experience abroad.
Take risk diversification. Do we really believe that in the day of stock index mutual
funds, options on individual stocks, and evolving credit derivatives that any firm must own another in
order to diversify its risks in virtually any way it cares to do so? I think not. If diversification of asset
return risk were our only goal, financial modernization would be easy. How about synergies in
crossselling? Maybe. But I think we must be skeptical here, because the admittedly weak literature on
economies of scope in banking has been hard pressed to find strong evidence of significant synergies
even in financial activities, although I think we all believe that there are some.
The argument that we need to combine banking and commerce to attract capital to
banking seems, well, pretty silly. In a market economy, capital flows to profit opportunities. If
banking is viewed as a vibrant and growing industry, it is hard to see why capital will be a problem.
Indeed, the banking industry just completed its fifth straight year of record profits, and it is no
coincidence that by all measures capital has been flowing into the industry. If it were not profitable, I
cannot see why we would want to create a structure to attract capital to banking.
The notion that mixing banking and commerce would reduce information costs in
bank lending, and would facilitate monitoring and management control by the bank probably has
some merit. Banks that hold both a debt and equity stake in a firm would probably be better able to
deter excessive risk taking by the other equity holders, and might even have access to better
information about the firm. However, the internalization of these principal-agent problems would
come at a price: a price that could include less vibrant money and capital markets, an unwarranted
expansion of the federal safety net, potentially dangerous conflicts of interest, and excessive
concentration of power. On balance, in my view, this is an area where we should be very cautious
and where we need far more research before we can come to any definitive conclusions.
An additional reason for caution is the necessity of modifying supervisory techniques.
I believe that all of the banking agencies can meet the challenges of expanded financial activities. But
adding commercial firms before we have digested the financial side of the business could well be a
bridge too far. Indeed, I believe that prudent public policy requires that, for this reason alone, we get
financial activities right before tackling further combinations of banking and commerce.
The thorny banking and commerce problem in financial modernization is that
nonbanking financial firms are already affiliated with commercial firms: some from commercial firms
creating financial subsidiaries, some from financial firms acquiring nonfinancial businesses. If
financial modernization allows all financial firms to affiliate, but prohibits banking and commerce,
the pre-existing commercial affiliates of nonbank financial firms would have to be divested to acquire
a bank, while banks could enter de novo the new nonbank financial activity without divesting any
valuable assets. This is either inequitable or the cost of acquiring a bank, depending on your point of
view. But, it is clearly a problem that has to be addressed. The choices are divestiture, grandfathering,
long-term phase outs, basket clauses, or combining of banking and commerce. It would seem to me a
poor public policy that opened up banking and commerce on pure equity grounds, rather than a
disinterested analysis of societal net benefits.
The Impact of Technological Change on Bank Risk Management
A strong case can be made for focussing bank reform today on the expansion of
permissible financial activities. The prohibitions against banking and securities and banking and
insurance combinations have always, it seems to me, been difficult to support. Moreover,
technological change has simply undermined the traditional distinctions among financial products and
services. In a word, the existing prohibitions are anachronistic.
One thing has remained consistent: Banks are in the business of taking and managing
risk, have always been and always will be. The change that we must cope with is that technology has
changed the ways they take risk, while at the same time improving their capability for managing it.
This creation and management of risk, like much of recent economic change, would have been
impossible without the dramatically lower cost of a unit of computing power. Indeed, before the
computer, most of the new bank products of recent years were merely concepts, concepts that could
not become operational until they were quantifiable. That's what the computer facilitated:
quantification of risk, the necessary prerequisite to price it accurately and manage it effectively.
Quantification did not change the fact that banks continue to deal with two very
oldfashioned risks: credit risk--will the counterparty perform as promised?--and market risk--will
changes in interest rates or other market factors reduce the value of my portfolio? Indeed, the special
skills of banks in evaluating and taking credit and market risk is what banks have leveraged in taking
part in the financial revolution spawned by the technical revolution. Nonetheless, the nature of the
newer products and the relationship with counterparties have meant that risks now manifest
themselves in a different way and that banks can modify their risk exposures much more rapidly than
ever.
Technology and the enhanced ability to capture and use data have changed risk taking
and its management in several areas: securitization, credit scoring, and modeling for pricing and
capital allocation, to name three. But no finer example of the revolutionary changes made possible by
technology can be found than derivatives. Banks and other creators of derivatives can now slice and
dice risks associated with a wide spectrum of underlying assets. Derivatives can be used to hedge risk
for the bank or its customers. Examples include interest rate swaps designed to make counterparties
more comfortable with their interest rate exposures and credit derivatives designed to reduce
correlations of risk in a loan portfolio. Of course, either of these instruments can be used to take risk
if the holder opts to hold the uncovered exposure, avoiding the cost of acquiring the underlying
assets. Moreover, a bank can change its position quickly--limiting a loss, diversifying or hedging a
risk, or closing out a position.
Derivatives, of course, do more than allow the taking or hedging of risk. They also
permit the holders to combine and separate risks to mimic virtually any financial activity. They thus
limit what regulators can prohibit, blur distinctions between instruments regulated by different
regulators, and virtually eliminate functional and other distinctions among commercial banks,
investment banks, insurance companies, and other financial institutions.
Supervising the Future Financial Services Holding Company
When it comes to considering how technology and new products have affected
supervision--especially of the future financial services holding company, with its wider powers--I
must begin by repeating an earlier comment: Banking organizations are still in the risk
business-taking it, managing it, profiting from it, and when they make the wrong decision or have bad luck,
bearing losses and perhaps even failing. And the basic risks still are credit and market risks. The
same expertise banks used for old-fashioned loans and their funding is still what they do for
derivatives, securitizations, and credit scoring.
That having been said, however, one must quickly add that the new instruments and
procedures raise real questions about both managing and supervising risk by instruments and/or by
legal entity. Banking organizations are doing so less and less, and as a result supervisors are
following suit. Banking organizations have increasingly centralized risk management at the parent as
a necessity because the credit decisions cross legal entities and certainly cross instruments. The new
technology has already created a supervisory imperative that financial modernization--with its new
permissible activities--can only accelerate: the need to evaluate risk policies and positions
centrally-most likely by one supervisor, sharing information with all legal entity regulators.
But, I must say, it is not clear to me precisely what this technology implies for the
legal entity regulators. If units of an organization, through combinations of puts and calls, can
simulate all the attributes of a security, or even most of the risks and returns of certain businesses,
what does the term "functional regulator" mean? Historically, when a legal entity--a unit of an
organization--was the only vehicle for participating in a certain function, the idea of separating
regulators by functions was consistent with legal form. It is increasingly less so when a synthetic
asset can be created with the same risk and return characteristics of the underlying asset.
Or, how comfortable should the individual regulator feel if a hedge involves as
counterparties two legal entities in the same failing organization? Will the regulator of unit A let the
gains booked in his unit offset losses in unit B, regulated by another entity? Can he do so under the
law? If the answer to either question is no, what good is such a hedge at a failing organization? Even
without complicating the issue by failure, how does the regulator of the unit booking the loss on the
hedge feel about the hedge, no matter how desirable the hedge is for the whole organization?
The new reality, it seems to me, is that supervisors have to supervise risk and not
instruments or entities. And that implies either that we keep organizations in old-fashioned
straightjackets and permit no new activities--a strategy which the market and technology has already
undermined--or we recognize that, over time, specialized regulators of banks, of securities firms, of
even insurance companies--are going to have to find a new paradigm.
We are, I believe, groping toward that future supervisory structure. At its center will
be an evaluation of risk management procedures and policies. Historically, bank holding company
supervision has dealt with an organization that was overwhelmingly a bank, and until Section 20s,
whose affiliates were engaged in businesses that could be conducted within the bank. The
supervisory approach was, not surprisingly, to apply bank-like supervision to the affiliates. The
designers of financial modernization legislation and the holding company or umbrella supervisor
must consider how to change that approach as bank affiliates increasingly are engaged in businesses
not permitted to banks, and possibly even subject to regulation by a nonbank regulator. At a
minimum, it is desirable to avoid redundant regulation. More basically, the necessarily intrusive
supervision of banks that comes with the safety net should not be extended to these new activities. In
part, such supervision would reduce efficiency and flexibility. In part, it would be unnecessary. And,
in larger part, it could create a moral hazard by fostering the wrong impression that a bank supervisor
has confirmed the strength of the supervised affiliate. Thus, the focus of holding company
supervision, as I noted, should be evaluation of risk management policies and procedures for the
organization.
Safety Net Subsidies and Organizational Form
Beyond regulatory structure, financial modernization--the linkage of banks to a wider
range of financial activities--also raises organizational structure issues. This issue is closely linked to
the subsidy provided by the federal safety net, a much discussed topic in recent weeks. By the safety
net I mean deposit insurance, and access to both the Federal Reserve discount window and the Fed's
payment system. While many of the questions associated with this topic are subtle and complex, I
believe that some of the more basic issues regarding the safety net subsidy can be understood using
straightforward economic reasoning. Unfortunately, much of the debate thus far has tended to be
more obscure than it needs to be.
Take, for example, the question of whether a subsidy exists. Most observers agree that
there is a gross subsidy, and that the real issue is whether there is a subsidy net of regulatory costs.
But here the discussion often seems to get confused. To me, it is critical at this point to distinguish
clearly between the concepts of total benefits, total costs, and marginal benefits and marginal costs.
We all know, at least those of us with some training in economics should know, that profit
maximizing firms will equate marginal benefits with marginal costs. Applied to the subsidy debate,
this principle implies that in equilibrium a profit maximizing bank should set the marginal benefits of
the subsidy equal to its marginal costs. In other words, rational firms should drive the net marginal
benefit of the subsidy to zero. Importantly, this implies that, at the margin, it may be very difficult to
actually observe the subsidy. I suspect that this goes a long way toward explaining why efforts to
estimate the marginal value of the subsidy have, to date, proved less than successful.
Even though rational firms equate marginal benefits and marginal costs, they clearly
do not equate total benefits and total costs. Indeed, standard microeconomic theory says that in a
competitive equilibrium total benefits should exceed total costs. Again applying this concept to the
subsidy debate, at any individual, profit maximizing bank the total benefits of the subsidy should
exceed the subsidy's total costs, even though the subsidy's marginal net benefit is zero. This total net
benefit allows the banking industry to be larger, and perhaps riskier, than it would otherwise be. The
fact that we do not observe banks voluntarily giving up their charters suggests that it may well be that
the safety net's total benefits exceed its total costs, even if the value of the net marginal subsidy is
zero.
Consider another point that derives from the distinction between total and marginal
benefits. Today, we would expect banks to be maximizing their total net benefits from the subsidy
using all of the activities in which they are capable of engaging. Now consider what a rational bank
will do if given a new opportunity, say expanded securities powers, to maximize profit. Wouldn't we
expect the bank to once again equate marginal benefits with marginal costs, including the marginal
benefits and costs of the safety net subsidy? But in the resultant new equilibrium, where the value of
the net marginal subsidy is again zero, would the total net benefits of the subsidy be the same as in
the previous, more constrained equilibrium? Clearly the answer is no. We would expect total net
benefits to be larger, and the banking industry to be larger, as it rationally sought to fully exploit the
new opportunities to make profits and exploit the subsidy. Rather than focus on measuring how large
the net subsidy is today, perhaps the more appropriate focus of our discussion should be on the more
speculative question of how the expansion of bank powers would enhance the value of the safety net
subsidy, and what would be the characteristics of the resulting competitive relationships.
Another key idea to keep in mind when thinking about the value of the safety net
subsidy is that we would fully expect the value of the subsidy to vary quite significantly across banks
and over time. The safety net subsidy can be thought of as deriving primarily from the confidence
that investors have in the belief that banks will be supported in times of financial crisis. This
confidence is reflected in lower total and marginal costs of funding for banks, including lower capital
requirements than otherwise would be the case. The economic value of this confidence is almost
surely rather low at very healthy banks during good economic times. However, the value can be very
much greater for any bank in financial distress, and can skyrocket in times of systemic financial
crisis. As Chairman Greenspan noted in congressional testimony recently:
What was it worth in the late 1980s and early 1990s for a bank with a troubled loan
portfolio to have deposit liabilities guaranteed by the FDIC, to be assured that it could turn illiquid to
liquid assets at once through the Federal Reserve discount window, and to tell its customers that
payment transfers would be settled on a riskless Federal Reserve Bank? For many, it was worth not
basis points but percentage points. For some, it meant the difference between survival and failure.
Empirical research on the option value of deposit insurance supports the point I am
trying to make. Estimates of the option value of deposit insurance, while subject to many caveats,
show that riskier banks have considerably higher option values.
What does all of this mean for the appropriate organizational form that future banking
organizations should take? Now that is, I need not tell this audience, a complicated question! But I
think the basic questions that we must answer are clear. First, assuming that one of the goals of public
policy is to not expand the safety net subsidy, what organizational form minimizes the chances of
such an expansion? Second, assuming that another goal of public policy is to limit the opportunities
for banks to exploit the moral hazard incentives inherent to the safety net, what organizational form
best ensures the safety and soundness of banks?
The holding company organizational structure has a proven track record of helping to
achieve both of these public policy goals. Indeed, years before I joined the Board, previous Boards
worked hard at convincing market participants that there is a clear distinction, in terms of access to
the safety net, between a bank and its affiliates. Market practice supports the view that we have
achieved considerable success at making this distinction. To me, it seems not only logical, but highly
desirable that we should build on this success as we continue to modernize our banking and financial
system.
When thinking about this issue, it is instructive to understand that in recent years bank
holding companies have in fact tended to move activities from the holding company back into the
bank. These activities had originally been put in the holding company to avoid geographic and similar
restrictions. As a result of this movement back into the bank, the nonbank assets held by holding
companies, excluding the assets of Section 20 securities subsidiaries, have declined by almost 50
percent over the last decade to 5.2 percent of consolidated bank holding company assets. When asked
why activities are being moved back into the bank, bankers often say that it is to take advantage of
the lower funding costs available at the bank.
One final point on this issue. It is certainly true that prudent managements of banking
organizations will weigh all the relevant factors, including the value of the safety net, when deciding
on the best organizational structure for their firm. However, the key point to remember is that those
organizations that stand to gain the most from the safety net in times of crisis--those with the highest
net subsidy and the strongest incentives to take excessive risks--are the most likely both to prefer and
to take advantage of any organizational structures that allow the greatest net subsidy. These are also
the organizations that are most likely to distort competitive relationships and expose taxpayers to
considerable risk. Thus, while allowing organizations a choice of organizational structure certainly
increases bank management's flexibility, it is not clear that allowing such choice serves the public
interest.
Conclusion
In closing, let me return to where I began. Financial modernization is a process that
must and will continue. But in the course of embracing and adapting to the future we must take care
to retain what is of value in the past, and be careful that critical public policy goals are achieved. The
separation of banking and commerce is an area where we should be particularly cautious. Once we
have mastered the art and science of supervising full service financial organizations, then perhaps we
should consider further combining banking and commerce. Technological change and financial
innovation are combining to change profoundly the way financial institutions measure, take, and
manage risk. These require that financial supervisors also adapt, and we need to move forward in this
endeavor. The development of full service financial organizations only reinforces the imperatives to
do so. When designing a system that maintains bank safety and soundness and constrains extension
of the safety net, organizational structure is not irrelevant. Here again it seems prudent that we should
be cautious, and build on structures that have proven their worth.
I am confident that a proper balance can be achieved between our sometimes
conflicting and always complex goals. Indeed, I look forward to trying to contribute to the ongoing
discussion and resolution of the challenges of financial modernization. Thank you.