INT’L FINANCIAL SYSTEM
JOINT CLASS TEN
FINANCIAL INTERMEDIATION
AND REGULATION
Prof. David K. Linnan
Univ. of South Carolina
School of Law
UI-UGM-USC-UNDIP-USU
Joint Videoconferenced Class
October 17, 2002
BANK VS. CAPITAL MARKET
What defines a bank traditionally?
Takes deposits (short-term obligations)
and makes loans (long-term assets), both
on balance sheet
What defines a capital market traditionally?
Purchase and sale of securities (equity or
debt, stocks or bonds), traditionally
through an underwriter (market risk, shortterm on balance sheet) in primary market
and through a broker (only settlement risk,
effectively off balance sheet except for
guaranty) in secondary market
BANK VS. CAPITAL MARKET
Re
general
theory
of
financial
intermediation, both in theory reallocate
capital based on supply & demand in a
perfect world to achieve allocative
efficiency
Traditional argument among financial
economists whether (capital) marketbased or bank-based financial systems
better in terms of economic performance
(understood in practice traditionally by
proxy
country
as
US/UK
versus
Germany/Japan financial system)
BANK VS. CAPITAL MARKET
Bank-Based Financial Intermediation View
Pro
Claim better for mobilizing (small into large) capital
Identifying good investments (project viability, individually
examined w/ lending due diligence)
Direct monitoring of managers in long run relationship
(contractual covenants too), but without potential negative
effects in making info publicly available (where it might
reach competitors)
BANK VS. CAPITAL MARKET
Bank-Based Financial Intermediation View
Pro (cont’d)
Active risk management & reduced information
assymetry given active due diligence possibility
Idea that the lower the general transparency level
and the weaker the institutional side of a
jurisdiction, the more suitable banks as powerful,
well informed actors (e.g., developed vs.
developing markets, or generically better where
institutional structures weak)
BANK VS. CAPITAL MARKET
Bank-Based Financial Intermediation View
Con
Powerful banks can protect established firms with close
bank-firm ties from competition (denying financing to
potential competitors)
Powerful banks with few regulatory restrictions on activites
may collude with firm managers against other creditors
By nature banks are highly leveraged & contain asset
(long-term) vs. liability (short-term) mismatch, so heavy
monitoring exercise of bankers themselves to avoid bank
insolvency (guarding the guardians, particularly given little
transparency and idea that state may suffer if required to
guaranty solvency generally)
BANK VS. CAPITAL MARKET
Capital Market-Based Financial Intermediation View
Pro
Transparency and
allocative efficiency
open
price-determination
enhance
By slicing up securities into different interests, more
efficient risk management (unbundling risks)
The incorporation of information dissemination into capital
markets structures may have collateral value (political
argument on monitoring “big capital,” but also ideas like
comprtition policy)
BANK VS. CAPITAL MARKET
Capital Market-Based Financial Intermediation View
Pro
Renders directly visible corporate governance
issues in terms of control (choice of equity vs.
debt too, vote & residual interest vs. fixed stream
of payments), also allowing agency arguments to
be addressed
Underlying claim that creating a public market
itself reduces most problems with banking
system approach
BANK VS. CAPITAL MARKET
Capital Market-Based Financial Intermediation View
Con
Claims well-developed markets may reduce individual
incentives to seek information
Claim that markets may permit too much liquidity in
permitting investor easily to buy in or out (short-termism,
plus tendency to sell out rather than really pursue coporate
governance as control)
Idea that long-term relationships on borrower side in
banking model more suitable, absent regulatory restraints,
in better serving industrial growth in participating in
insurance & securities activities (concept easier for a bank
to function in capital market than it is for a securities
company to function like a bank in its markets)
BANK VS. CAPITAL MARKET
BANKS VS. CAPITAL MARKETS
Current view on the law & economics side of
development economics is that the institutional
structures (banking vs. capital markets) not
nearly as determinative of economic growth as
strength of underlying legal structures (so
whether you have functioning bankruptcy law or
contractual
enforcement
generally
more
important)
Problem of mistaking common law versus
civil law question as “better” for economic
growth, but really public law orientation
FINANCIAL INTERMEDIATION
All of the preceding analysis institutionally oriented, meaning
regulation of banking as industry selling “banking
products” vs. capital markets as industry selling “capital
markets products”
More modern view says as both industries have deregulated,
either need to regulate by function or by product (to extent
post-deregulation in developed markets argue both overlap
in selling each other’s services/products in different
formats (whether universal bank, meaning the European
bank-based
systems
incorporate
capital
markets
operations like Deutsche Morgan Grenfell as well as selling
insurance; or financial supermarket, meaning traditional
US commercial banks like Citibank buy securities
companies like Salomon Smith Barney and Travellers
Insurance)
FINANCIAL INTERMEDIATION
FUNCTIONAL SERVICES FOR REG PRACTITIONER (BANKING
SUPERVISORS)
Access to payment system (electronic transfers vs. cash)
Access to liquidity on demand (demandable deposit versus
standby credit)
Packaging and selling financial risk, meaning not only
things like generic insurance but also securitization and
reinsurance
Information/quality certification (attendant to repackaging
function, meaning generic versus brand)
Conduit for government guarantees (whether access to
lender of last resort, or deposit insurance)
FINANCIAL INTERMEDIATION
FUNCTIONAL SERVICES FOR FINANCIAL ECONOMISTS (FINANCIAL
MARKETS ORIENTED)
Methods of clearing & settling payments
Mechanisms for pooling of resources
Ways to transfer economic resources through time & across
distances
Methods of managing risk
Price information to help coordinating decentralized decisionmaking in different economic sectors
Ways of dealing with incentive problems resulting from info
asymmetries or agency problems
FINANCIAL INTERMEDIATION
Banking regulator’s view is that banks themselves
can no longer be supervised on a transactional
basis for technology and deregulation reasons
(note the prior example of universal bank versus
financial supermarket, differing ultimately more in
view of what goes on balance sheet)
Financial economist’s view is that product or
functional regulation is the way to go because of
innovation under deregulation (e.g., now
derivative markets there since circa 1985) plus
interchangeability of products means that
investor strategies can be accomplished many
ways
FINANCIAL INTERMEDIATION
FINANCIAL ECONOMIST’S VIEWS OF EQUIVALENT TRANSACTIONS
Taking a leveraged position in S & P 500 stocks (equity investment):
Buy each stock individually on margin (direct equity investment financed
by broker)
Buy Vanguard S & P 500 index fund and borrow on your mastercard
to finance it (pooled equity investment financed initially by bank until it
securitizes its credit card receivables and sells them into capital markets)
Buy publicly traded futures contract on S & P 500 (publicly listed
derivatives, traded through securities company)
Buy OTC forward contract on S & P 500 (privately traded derivatives, can
be bought from bank or securities company)
You can borrow from a bank to buybuy a variable rate annuity contract
from an insurance company with return linked to S & P 500 (insurance
product bank- financed), etc.
FINANCIAL INTERMEDIATION
The difference in functional versus institutional perspective is that
the options are equivalent but cast the transactions under
different regulatory schemes
So if you want to regulate institutionally, pushed to either reregulate (de-deregulate by limiting flexibility of financial
intermediaries by category to sell only traditional products of their
categories)
If you regulate functionally, you get go back to core functions lists
and interrogate any financial intermediary on how the product fits
the list and what attendant risks are that regulation is supposed to
ameliorate as
1.
2.
3.
Consumer protection
Systemic risk
Moral hazard if external guarantees (government
deposit insurance domestically, IMF bailout
internationally)
FINANCIAL INTERMEDIATION
COMPARE (1) REGULATORY PRACTIONER’S & (2) FINANCIAL ECONOMIST’S
FUNCTIONS FOR FINANCIAL INTERMEDIARIES
(1) Access to payment system (electronic transfers vs. cash)
(2) Methods of clearing & settling payments
________________
(1) Access to liquidity on demand (demandable deposit versus standby credit)
(2) Ways to transfer economic resources through time & across distances
________________
(1) Packaging and selling financial risk, meaning not only things like generic
insurance but also securitization and reinsurance
(2) Methods of managing risk
________________
(1) Information/quality certification (attendant to repackaging function, meaning
generic versus brand)
(2) Mechanisms for pooling of resources
________________
(1) Conduit for government guarantees (whether access to lender of last resort, or
deposit insurance)
(2) Ways of dealing with incentive problems resulting from info asymmetries or
agency problems
____
FINANCIAL INTERMEDIARIES
THE ONLY DIFFERENCE?
(2) Price information to help coordinating
decentralized
decision-making
in
different
economic sectors
SO IS THERE ANY DIFFERENCE BETWEEN
THE BANKING REGULATOR’S VERSUS
THE FINANCIAL ECONOMIST’S LIST, AND
WHY/WHY NOT?
FINANCIAL INTERMEDIARIES
THE ONLY REAL DIFFERENCE SEEMS TO BE ECONOMIST’S IMPLICIT FOCUS
ON DERIVATIVES AS NEW INSTRUMENTS NOT FALLING INTO
TRADITIONAL BANKING OR CAPITAL MARKETS PRODUCT CATEGORIES,
AND THEY ARE IN BOTH MARKETS, E.G., EQUIVALENT TRANSACTIONS
PROBABLY DERIVATIVE BASED:
Buy Vanguard S & P 500 index fund and borrow on your mastercard
to finance it (pooled equity investment financed initially by bank until it
securitizes its credit card receivables and sells them into capital markets)
Buy publicly traded futures contract on S & P 500 (publicly listed
derivatives, traded through securities company)
Buy OTC forward contract on S & P 500 (privately traded derivatives, can
be bought from bank or securities company)
You can borrow from a bank to buy a variable rate annuity contract from
an insurance company with return linked to S & P 500 (insurance product
bank- financed)
FINANCIAL INTERMEDIATION
DERIVATIVES ARE REALLY JUST ABOUT RISK MANAGEMENT, E.G.,
SLICING UP RISKS SUCH AS
Insurance risks (weather bonds, commodities contracts, but also
for terrorism risks could go to Lloyds for war risk insurance
meaning hostile action like against the French ship a week ago, or
just buy a put for Jakarta stocks at BES, or rupiah forward
contract from an Indonesian or Singapore bank)
Foreign exchange risks (all foreign currency bonds, for example
those sold by Indonesian companies in Singapore pre-1997, or
currency swaps from a bank, etc.)
Banks now sell credit derivatives (e.g., if a big borrower were to
default on a loan the credit derivative as a kind of guaranty
provides for 3-p payments in place of borrower)
THE ISSUE IS THAT DERIVATIVES TEND TO BE LEVERAGED
BETS AND DIFFICULT TO VALUE SINCE TIED TO CONTINGENT,
EXTERNAL EVENT
BASEL STANDARDS
LOOK TO BIS & BASEL CAPITAL ACCORDS FOR WISDOM PAST 10 YEARS
AND PROSPECTIVELY
Since 1992 risk-based 8% Basel capital requirements, with real issues in
haircut weighting (older style liquidity guarantee, unforeseen incentives
and valuation/risk estimation problems)
Current proposal (for 2006 implementation theoretically), three pillars are
1.
Minimum capital requirements (still 8% in theory, but
now modelling credit, operational & market risk w/ banks
able to determine internally)
2.
Supervisory review, of internal risk
assessment and controls (note not trad. transaction based super.)
3.
Market discipline (meaning do detailed risk disclosures
and the markets will tell you the bank’s market capitalization)
WHERE IS THE DISTINCTIVE BANKING REGULATION APPROACH NOW?
US BANKING REG HISTORY
HOW WE GOT HERE
National Bank Act of 1864
Pre-existing state banks (free banking
tradition since 1838, meaning not a
specific charter as business license),
so created dual banking system and
defined “business of banking” as to
this day deposit-taking & extension
of credit
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Federal Reserve Act of 1913
Created Federal Reserve as central
bank plus gave prominent role in
banking supervision
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Edge Act of 1919
International banking authorization for
banks to create special purpose subs
(so Citi is not new phenomenon)
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
McFadden Act of 1927
Established
dominance
of
state
banking laws to determine interstate
banking
structures,
essentially
prohibiting interstate branching in
theory to preserve community
banking
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Banking Acts of 1933 & 1935
As response to 1930s banking crisis,
1. separate commercial from investment banking
(so commercial banks could not be universal
banks in European model, investment banking
being core capital markets activity),
2. established interest ceilings on deposits,
3. established FDIC as insuror with regulatory
powers,
4. restricted bank activities particularly interlocking
directorates and insider lending,
5. generally broadened supervisory powers
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Federal Home Loan Bank Act of 1932
and Federal Credit Union Act of 1934
Established parallel institutions with
special housing & mutual markets
covered also by insurance, with own
parallel regulatory structure
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Bank Holding Company Act of 1956 &
1970 amendments
Federal regulation for bank holding
companies under Federal Reserve, in
effect upholding longstanding rule
that financial & industrial sector
ownership separated
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Savings & Loan Holding Company Act
of 1967
Parallel S & L regulation like BHCA,
but under FHLBB
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Depository Institutions Deregulation & Monetary
Control Act of 1980
1.
2.
3.
4.
First big deregulatory financial sector statute,
phasing out deposit interest rate ceilings,
Expansion of permissible S & L activtties
Authorizing
nationwide
NOW
accounts
(negotiable order of withdrawal, a special
check-like instrument)
Background of S & Ls suffering asset & liability
mismatch & opening up competition in sector
more generally
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Garn-St. Germain Depository Institutions Act
of 1982
1. Authorised money market deposit
accounts (basically, competition from
mutual fund industry selling commercial
paper destroyed interest rate ceiling & this
duplicated competition’s product),
2. Strengthening S & L industry again
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Competitive Equality Banking Act of 1987
Targeting so-called non-bank banks as
unregulated
lenders,
given
that
businesses were trying either to not take
deposits (usually), or not make loans
going all the way back to 1864 banking
activity definition, but grandfathering
institutions like consumer finance &
industrial lenders (Household Finance, GE
Credit, etc.)
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Financial Institutions Reform, Recovery and Enforcement Act
of 1989
1. Replaced FHLBB with OTS in Treasury as supervisory
authority for S & Ls,
2. Created Resolution Trust Corporation (RTC) for
managing failed thrifts & selling assets,
3. Re-regulated much of S & L asset side (investments,
meaning lending mostly), cutting back on non-housing loan
activities plus commercial real estate lending
Functionally, a decent burial for the S & L industry debacle of
1980s
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Riegle-Neal
Interstate
Banking
Branching Efficiency Act of 1994
and
Basically undid the McFadden Act in
enabling interstate branching and so
nationwide branching (in part in response
to pressure on S & L side, meaning banks
threatened to convert to thrifts, since they
did not have the same constraints)
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
Gramm-Leach-Bliley Act of 1999
Basically undid formal prohibition in Glass-Steagall
Act of commercial banks doing investment
banking activity and 1956 BHCA of insurance
activity if done through a bank holding company
structure, with the result that we now have
Citigroup,
meaning
CitibankSalomonSmithBarney-Travellers as “financial
supermarket”-however, there had been
regulatory loosening since early 1980s under
regulatory interpretation of what was permitted
“banking business,” etc.
US BANKING REG HISTORY
HOW WE GOT HERE (Cont’d)
How do you regulate Citigroup realistically as a worldwide financial
conglomerate? Instead, drifting under Basel Accord towards what begins
to look a little like capital markets SRO self-regulation….
We have gotten here because
1.
technology changing the nature of financial services,
2.
the sheer size of institutions like Citi (growing concentration),
3.
blurring of lines re financial products such as uninsured money
market funds as SEC-regulated investment companies investing in
commercial paper versus traditional insured bank deposits, and
4.
financial engineering practices like securitization and the secondary
mortgage market with GNMA guarantee under which for housing we really
no longer need S & Ls as real dedicated lenders.
OTHER MODELS?
HOW WE GOT HERE (Cont’d)
What are the appropriate regulatory models outside US (consolidated
financial sector regulators looking at UK first)?
US probably stuck with Fed as central bank vs. Fed Banking
Regulators (OCC, FDIC, Fed) vs. State Banking Regulators vs.
SEC vs. State Blue Sky vs. CFTC vs. Credit Unions, etc. and
federal/state regulatory split on insurance generally as matter of
political economy,
1.
Unless and until we have a high-enough profile
financial
institution debacle to trigger another round of regulatory reform.
2.
So, was Enron that debacle in waiting or is it really a
regulatory success?
3.
In what regulated
engaged?
business, if any, was Enron actually