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August 1, 1995

eCONOMIG
GOMMeiMTCIRY
Federal Reserve Bank of Cleveland

Regulation and the Future of Banking
by Jerry L. Jordan

Ihe future of banking cannot be dishe
cussed without talking about regulation.
Simply put, regulation is what has defined banking as we know it. For more
than 60 years, the Glass-Steagall Act
has defined what a banking organization
has been allowed to do; the Douglas and
other bank holding company acts have
defined the corporate form required to
do it; the national or state banking
authorities, deposit insurance agencies,
and Federal Reserve have defined how
to do it; and their supervisors and examiners have tried to ensure that it was
done that way.

I am optimistic enough about our political system to believe that if a regulation
is not producing some benefit commensurate with the burden it imposes on
consumers, such regulation eventually
will be removed — if not erased, then at
least not enforced. To start envisioning
the future regulatory environment of
banking, we can pose two questions.
What kinds of regulation will be necessary in the future, and how fast might we
expect to move from today's outmoded
system to an era in which different regulations make more sense?

•
The reason we can discuss the future of
banking without focusing entirely on
regulation is that the current highly fragmented regulatory structure simply will
not serve the needs of the twenty-first
century. The power of private property
rights operating through a market economy is that, if consumers want something and are willing to pay the price,
producers will find a way to supply it.
Regulatory restraints impede market
adjustments to shifting demands. Emerging technologies and individuals' ingenuity will ultimately get over or around
those regulatory barriers, but it will take
time and absorb resources.
In short, regulation "gums up the works."
In the end, it will not prevent producers
from satisfying consumers' desires
except at the margin, where higher costs
and prices convey the burden of regulation to the consumers who must bear it.

Regulation Today

Our current regulatory framework is a
product of the 1930s, designed under
emergency conditions of economic
depression that we all hope henceforth
will be irrelevant. More important, the
regulatory framework was created on the
crest of the intellectual wave of belief
that government intervention could
make the world better by planning and
controlling economic activity.
Now, despite stunning advances in computer and communications technology
that might facilitate centralized control,
the wave of belief in the efficacy of government intervention has crashed. As a
result, hundreds of millions of people
around the world have been freed to rely
on their own initiative and on private
markets, without conforming to a government plan — except in our financial
sector. Here, statutory distinctions remain
in place, guiding financial activities.

How must the regulatory structure of
the financial industry change to meet
the needs of the next century? The
answer involves dismantling traditional partitions that have separated
firms, rethinking functional regulation policies, and squarely facing the
problem of moral hazard created by
the federal safety net.

The landmark financial legislation of the
1930s created distinctions among three
financial market boxes — labeled
"depository institutions," "securities
underwriting and sales," and "insurance
underwriting and sales." In principle,
each of these gigantic boxes could be
subdivided into constituent compartments: Depositories included separate
compartments for commercial banks,
savings and loans, mutual savings banks,
credit unions, and industrial banks; the
securities industry was subdivided into
brokerage firms, securities dealers, mortgage companies, and finance companies;
insurance included brokers, dealers,
underwriters, and rating agencies.
As long as all these compartments contained separate, noncompeting markets,
then regulators could try to enforce different rules within each box. With little
danger of substitution, the costs of regulation could be added to price in one
compartment without many customers
fleeing to other compartments. Regulators' rules could be defined to secure a

public purpose thought to be superior to
the results of unregulated competition
within each compartment.
Today, these Glass-Steagall regulations
still force depository institutions to fit
themselves into one box only. Regulations are still designed as though banks
do not compete with firms in the other
boxes. Nevertheless, depository institutions, securities firms, and insurance
companies all cater to the needs of common customers.

•

Regulation in the Future

Sometime in the future, these arbitrary
regulatory boxes will be thrown away.
Over the years, in fact, any natural walls
separating financial compartments have
largely fallen away, leaving increasingly
flimsy partitions made up of regulatory
restrictions whose major purpose was to
preserve tidy compartments.
Three kinds of restrictions have been used
to maintain these partitions: restrictions
on price, restrictions on location, and
restrictions on product. In general, price
restrictions are no longer important in
banking. For example, Federal Reserve
Regulation Q, which set differential maximum interest rates on time and savings
deposits at banks and thrifts, was dismantled between 1980 and 1986 in compliance with the Monetary Control Act.
Statutory prohibition of interest payments on demand deposits, enacted to
prevent bank failures due to destructive
competition, is largely irrelevant today.
Increasingly, with everyone wired together by telecommunication networks,
the ability to access interest-bearing
credit balances on the books of every
reputable firm will make useless any
arbitrary definition of a "deposit."
Regulatory restrictions on location also
are a dead issue for the future of financial services. Under the provisions of
last year's Riegle bill, almost-universal
interstate branch banking will be possible and seems likely after 1997, unless
an unexpectedly large number of state
legislatures vote to opt out.
hi addition, the end of product restrictions is near. For example, a principal

argument for the separation of commercial from investment banking under the
Glass-Steagall Act was that, if the two
were combined, banks would use their
underwriting business to repackage their
bad loans as bonds, which they then
would foist off on a gullible public. Neither logic nor historical evidence supports this argument. Customers are not
dupes, and a bank's long-run investment
in reputation is not worth throwing away
for any short-term profit gained from
selling bad bonds.
If there is to be any product regulation in
the future, it should not follow today's
approach, under which bank regulators
require companies to ask permission to
change what they are doing. Banks have
needed permission to branch, to merge,
to form a holding company, and to
acquire a subsidiary or affiliate. The
underlying philosophy has been, and
remains, "Prove to the authorities that
you should be allowed to do this."
I have a fundamental philosophical
objection to this approach. Constitutionally, government is supposed to bear the
burden of proof if private citizens are to
be constrained from following the dictates of self-interest. Instead, banking
regulation forces private citizens to bear
the burden of proof that they be permitted to act in their own self-interest.
We should put the shoe on the other foot.
Adopt an information approach, closer
to that of the Securities and Exchange
Commission (SEC). Let firms notify
regulators of an innovation, then let the
regulator take the initiative to intervene
within a reasonable time with a demonstration that costs exceed benefits. Let
the public record and accounting statements reveal what firms are doing and
how well they're performing in the market. This is not heresy. Other nations do
it in banking, and in this country, regulators outside of banking do it. We're not
in the 1930s—let producers take responsibility for what they do.

•

Functional Regulation

Doing away with Glass-Steagall boxes
will not clean the future regulatory slate
entirely. The legal framework of finance
and commerce will remain, including

laws that discourage fraud and misrepresentation, guard against anticompetitive
practices, and require timely release of
accurate information.
It is less obvious what to expect about
so-called "functional regulation" in the
future. Functional regulations are those
rules unique to each of the GlassSteagall boxes and compartments. Examples are SEC shelf registration in the
securities box, reserve requirements in
the banking box, and policy reserves in
the insurance box.
Reserve requirements provide a good
example of a functional regulation moving toward extinction because its costs
exceed its benefits. Reserve requirement
levels have been reduced repeatedly
over the past 60 years, just as developments in computer technology have
made them cheaper to avoid.
The potency of a functional regulation
should be expected to decline when
costs rise relative to benefits. This may
seem to be an encouraging lesson about
the rationality of our regulatory world.
Note, however, that rationality prevails
only in the present. No matter how convincing the initial case for adopting a
regulation may be, it must be reassessed
continuously. Sunset provisions are the
effective way to ensure reassessment:
Let regulations lapse on a known date
unless proponents can muster new evidence of a net benefit.

• Regulation and Moral Hazard
It might be nice to stop here, saying that
we should look forward to an unregulated financial services industry in the
next century. The reason I cannot stop
with that is the same reason that Congress has had such difficulty in adopting
financial reform legislation.
Moral hazard is the problem. It is created
by the federal safety net, including Fedwire finality, the discount window, and
deposit insurance. The financial structure
of the future will depend largely on what
is done about moral hazard.
Transactions deposit liabilities of depository institutions are a primary medium of
exchange in our economy and a primary

store of value in our financial system.
Businesses that have access to the safety
net thereby are better credit risks in
some ways than those without access.
Lenders who give credit to those with
access need not be as painstaking in their
credit evaluations or can lower the risk
premium they demand when lending,
because they are aware that the safety
net is available. In these ways, the safety
net subsidizes borrowing and risk-taking
by those with access.

• Coinsurance is a feature that could be
combined with others, as long as no
bank were considered "too big to fail."
Coinsurance would pull back from 100
percent insurance of deposits within the
current $100,000 per account limit.
Instead, starting at zero or more, depositors would absorb a portion of any loss.
This would reintroduce into deposit markets some of the discipline that safety
net guarantees have removed.

•
The tough problem is how to remove
restrictions between the payments business of banking and all the other businesses in which an unfettered conglomerate firm might want to engage. How
can banking become part of everything
else without, at one extreme, removing
the safety net subsidy or, at the other
extreme, extending both the safety net
subsidy and prudential supervision to
everything else? Between these two
extreme solutions are a few more familiar suggestions:
• Proponents of "narrow banking"
would charter specialized, safe banks,
allowed to invest only in cash and other
ultrasafe assets and to issue monetary
liabilities. All other financial and nonfinancial business would be conducted
from firms with no safety net available
to them.
• Advocates of "firewalls" aim at a
similar result. Some proposals, such as
that of Jim Leach, chairman of the
House Banking Committee, would allow
both bank and nonbank subsidiaries
within a financial services holding company. Only the bank subsidiary would
have access to the safety net, with limitations on overlapping personnel and
intersubsidiary transactions to limit
spillovers of the safety net subsidy to
other lines of business.
• Other proposals, associated with the
current administration and the Office of
the Comptroller of the Currency, would
rely on the formation of bank subsidiaries, rather than on holding company affiliates, to carry on the nonbanking activities of a conglomerate firm.
How this proposal would deal with
moral hazard is unclear.

How Soon Is the Future?

Some contend that this is the year for
financial reform legislation. Of course,
such things have been said before, but all
we saw were piecemeal revisions. Last
year's interstate branching legislation
was perhaps the most substantial change
since Glass-Steagall.
I do see reasons, however, for thinking
that the current Congress will enact
more complete reform legislation. A
number of powerful forces are at work
that, in combination, suggest that something must happen, and soon.
First, banks, their competitors, and their
customers are in the process of planning
for the new interstate banking environment of 1997. But planning what? To
plan effectively, they need either affirmation that existing regulatory ground rules
will not be removed, or, alternatively, a
sense of the extent to which financial reform will proceed. Congress can expect a
lot of pressure from major players who
are tired of procrastination and who need
a more definitive basis on which to plan
for the next five to ten years.
The second reason for expecting genuine
reform is the visible disequilibrium in the
regulatory framework itself. The structure dictated by the Glass-Steagall Act,
which successfully prevented banks from
doing new things for several decades,
now seems to be disintegrating before
our very eyes. The Office of the Comptroller of the Currency has made a preemptive strike at reform, suggesting that
it may offer national banks substantially
greater freedom to enter nonbanking
lines of business through bank subsidiaries. If this effort prevails, the alwaysdelicate balance between the attractions
of national and state charters will be

tipped decisively. For state charters to
regain franchise value, substantial further
steps will need to be taken to loosen regulatory constraints on state-chartered
banks, their branches, and their holding
companies.
A third reason to expect congressional
reform is the deposit insurance premium
issue, which in the short run is building
even more insistent pressure for change
than the Comptroller's initiatives. The
Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF)
both charge close to the same premium.
BIF premiums are slated to drop soon,
because the insurance fund has been replenished after a severe drain a few years
ago. SAIF premiums for thrift deposits,
however, cannot be reduced in the foreseeable future because the SAIF insurance fund has not been replenished, and
because SAIF premium income also
services the bonded indebtedness of the
Financing Corporation (FICO). The result is an impending 19-basis-point cost
and price disadvantage for thrift deposits.
Already, the BIF/SAIF issue is having
predictable results. SAIF members that
are in sound condition are applying for
BIF-insured bank charters in order to
channel deposits to the banks. As a
result, SAIF will be subjected to a fundamental shock that, if left to play itself
out, would leave the fund insuring the
residual deposits of institutions unable to
escape. SAIF premium income would
decline, and FICO bond service would
be in jeopardy.
This unresolved issue illustrates a powerful disequilibrium in the financial markets today that will not be ignored.
Instead, it promises to become part of
the political horse-trading and congressional logrolling that will produce fundamental reform of the regulatory structure
of U.S. financial markets.
Underlying all of these pressures for
change is a fourth, more fundamental
force. The 1930s' intellectual conceit
that subdivided businesses and products
into neat regulatory boxes and compartments was nothing more than that — a
conceit. Changing technology alone

doomed this effort. Especially as the
computer and telecommunications revolution created boundless opportunities
for innovation, including money market
mutual funds and sweep accounts, the
compartments became purely imaginary
regulatory constructs.
The end is not in sight. ATM network
sharing and credit card companies have
produced nationwide — approaching
worldwide — networks that only visionaries imagined possible 20 years ago.
Close to 30 percent of U.S. households
have home computers of some description. It's not outlandish to expect that
telecommunications networks like Internet will link a critical mass of households and almost all businesses within a
few years. The opportunities this creates
for innovations in commercial and financial markets cannot be predicted, but
surely are enormous. Just as great, I
believe, are the opportunities for crossing Glass-Steagall boundaries among
regulatory compartments.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Address Correction Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.

•

Conclusion

The regulatory structure of the 1930s is
disintegrating, but financial reform
involves both a rock and a hard place.
The hard place is the inevitable jockeying of various interest groups to
advance their respective competitive
advantage. Each group claims to want
its own version of reform, and contends
that no reform would be preferable to
the proposals favored by other groups.
However, the rock that prevents movement past this hard place is how to limit
access to the federal safety net.

Jerry L. Jordan is president and chief executive officer of the Federal Reserve Bank of
Cleveland. This Economic Commentary was
excerptedfrom a speech that President Jordan presented to the fourth annual Financial
Industry Conference at Middle Tennessee
State University in Murfreesboro, Tennessee,
on April 24, 1995. Members of the Federal
Reserve Bank of Cleveland staff, particularly
E.J. Stevens, have contributed significantly
to this paper.

How can legislation remove the regulatory partitions without thereby removing
the full measure of market discipline
from activities newly associated with
payment services? Can the federal agencies provide credible assurance that they
will not come to the rescue of firms that
get into trouble in activities other than
payments? Will reform be possible without taking the path of least resistance,
the path of broadening access to the
safety net? All I can say is, "Stay tuned."

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