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For release on delivery
10 45 a m , HST (4.45 p.m. EDT)
October 11, 1988

Innovation and Regulation of Banks in the 1990s
remarks by
Alan Greenspan
Chairman, Board of Governors of the Federal Reserve System
before the
American Bankers Association
Honolulu, Hawaii
October 11, 1988

It is a pleasure to have the opportunity today to
address members of the American Bankers Association.

As you

may recall, a minor mishap in securities markets came
between us last year

I have one request at the outset--if

anyone knows how the stock market closed today, don't tell
me until I've finished.
That we can joke a little about the events of a
year ago is a tribute to the resilience and adaptability of
our financial markets and economy.

Nonetheless, such

occasions do remind us of the speed and suddenness with
which markets can move today, and the potential impacts of
such movements on investors and financial institutions.
Even before last October's events, there was
increased concern about potential instabilities in the
financial system.

Such concern arose as a consequence of

the major changes in the financial landscape that have
occurred in this decade--changes that in some cases are
continuing and even accelerating.

I shall spend only a few

minutes reviewing them, concentrating on their implications
for the business of banking, and for the regulation of banks
and other depository institutions.

As you adapt, so must

we, and that is the focus of my remarks today
At the very beginning I would highlight two
points

First, the goals of depository institution

regulatory policy may be stated quite simply--to avoid the

-2risk of systemic failure of the insured depository system,
to promote competitive and efficient capital markets, to
protect impartiality in the granting of credit, and to
prevent extension of the safety net to nonbanking
activities

Second, change is inevitable and, while it may

bring the potential for increased risk, if properly managed,
it is also likely to bring improvements in economic and
social welfare

The regulator's job is to adapt to change

in ways that preserve its benefits while maintaining the
stability of the financial system
Key Changes in Recent Years
Over the past decade our financial landscape has
experienced a number of key, and often interconnected,
changes.

Advances in computer and telecommunications

technology have enabled both borrowers and lenders to more
easily, and at lower cost, obtain and use credit- and
market-risk information.

In important ways, this has

displaced and substituted for some of the key traditional
economic functions of banking

Many new financial products

have resulted from this technological revolution in
information processing that challenge traditional bank loans
and funding techniques

It seems reasonable to assume that

the trend toward direct investor-borrower linkage, or more
securitization, will continue
Moreover, financial markets have become
increasingly international in scope, and the resulting
intensity of competition has put increased pressures on the

-3profit margins of many depository institutions

When

combined with the revolution in information processing, the
increased speed with which assets can be shifted around the
world in liquid markets has accentuated the need for
effective risk management policies by both depository
institutions and regulators
A significant element in financial change, the
deregulation of interest rates and selected product lines in
the United States and some other nations, has improved the
overall conipetitiveness and efficiency of capital markets
But they have also removed hitherto protected sources of
funds to depositories, potentially exposing them to
increased interest rate risk, and added pressures on profit
margins

Similarly, the breakdown of barriers to interstate

banking in the United States, while providing opportunities
for geographic diversification and more open access to new
markets, also has increased pressures on some institutions
Today, all but five states have passed some form of
liberalized interstate banking law.

There is every reason

to believe that the competitive pressures brought about by
the deregulation of interest rates, product lines, and
geographic limitations will continue
Finally, macroeconomic events such as the sharp
increase in inflation and interest rates in the late 1970s,
the severe recessions of the early 1980s, the steep decline
in oil prices, and the October 1987 stock market crash,
have, as seems evident, induced people in general, and

-4financial market participants in particular, to expand their
expectations regarding the potential volatility of asset
prices and other economic variables.

In other words, these

events have not only caused severe contemporaneous problems,
they have also injected a new and higher degree of
uncertainty, or risk, into projections of the future.

This

reaction highlights the fundamental interdependencies
between the macroeconomy and the financial markets that any
policymaker--but especially one in the central bank--must
recognize.

For all the new techniques for shifting risk

around the financial system, the ultimate safety and
stability of that system depends on the stability of the
economy on which it is based, and that economy cannot itself
behave in a stable and predictable fashion if the markets in
which claims on saving and capital are allocated are subject
to waves of concern about key participants.
Key Components of Policy Response
The implications of these changes for the
regulation of depository institutions are varied and
complex.

I believe the way to begin responding to both

today's and tomorrow's economic environment is to fortify
the natural "shock absorbers" of the financial system-capital and liquidity—and concurrently to make better use
of market and market-like incentives to discourage excessive
risk-taking at individual depository institutions.

There

must be a symmetry of risk for owners of depository
institutions; those who stand to gain substantially if the

-5institution is successful must also stand to lose
substantially if outcomes are not so favorable.

Surely, one

lesson from the experience with some troubled depository
institutions in recent years is that unbalanced incentives
to assume risk, arising when the federal insuror absorbs
losses while the owners reap profits, can lead to
destabilizing behavior.
The key to engendering market incentives, and at
the same time providing shock absorbers for depository
institutions, is to require that those owners who would
profit from an institution's success have the appropriate
amount of their own capital at risk

Capital acts as a

buffer against unexpected shocks to a firm, and thereby
helps to insulate both individual firms, and the system,
from risk.

There is no better way to ensure that owners

exert discipline on the behavior of their firm, than to
require that the owners have a large stake in that
enterprise

The need for larger shock absorbers and for

increased private incentives to monitor and control risk are
the fundamental reasons why increasing the amount of capital
in the depository institution system has been a major goal
of Federal Reserve regulatory policy in the 1980s.

To the

extent that we succeed, we will have begun to lay a solid
foundation for the 1990s
Some may argue that raising capital standards will
put banking organizations at a competitive disadvantage
This strikes me as short-sighted

Well-capitalized firms

-6can be counted on to be around in the future, and thus
worthy of customers' willingness to establish long-term
relationships

Moreover, while the capital ratios of bank

holding companies generally have been rising during the
1980s, they still tend to be considerably below those at
nondepository financial firms

In many cases, this no doubt

reflects real or imagined protection by the federal safety
net

This tendency toward over-reliance on the safety net

by both owners and depositors has inhibited, and in some
cases may have eliminated, the private market signals that
would have made much less likely many of the portfolio
problems now facing numerous depository institutions.

Thus,

the safety and soundness of the financial system requires
that banks have adequate capital.
For many banks this means increased capital
requirements.

I recognize that some of these banks, not

feeling market pressures to raise capital ratios, may
consider increased capital requirements unnecessarily
burdensome

However, given the existence of the federal

safety net, market signals regarding the level of capital
may not be appropriate from a broader perspective

The

safety net has the effect of overriding some forms of market
discipline, and the implied partial backing of the federal
government for some bank funds means that incentives for
banks to maintain adequate capital are weakened
Bank reluctance to raise equity in capital markets
may also be based, to an extent, on comparisons of book and

-7market values of equity and the apparent consequences of a
shortfall in market value for shareholder dilution.

But the

relevant consideration is clearly enhancing the market value
of the firm over time

High capital banks will be the ones

that can react to the changing environment and profit from
new opportunities
Regulatory policy can and should do more than
merely raise the level of capital.

A risk-based system of

capital standards should help to deter excessive risk-taking
by individual banks, and the greater capital costs imposed
on higher risk banks will imply a fairer distribution of
capital requirements within the banking system

These

principles are well-known and well-utilized in private
markets—higher risk borrowers are charged higher interest
rates on loans in money and capital markets, and higher risk
insurees are charged higher premiums by insurance companies
Bank regulators took a major step forward this
past summer, when virtually all of the major industrial
nations agreed to implement a risk-based capital system by
the end of 1992.

Everyone realizes that the scheme adopted

is far from perfect

Indeed, in recognition of the fact

that the framework does not take account of all the risks to
which banks may be exposed, I believe that banking
organizations generally should be encouraged to operate
above the minimum capital ratios specified in the accord.
This is especially true for institutions undertaking rapid
expansion, or those with operational or financial

-8characteristics that are of supervisory concern.

In

addition, it is clearly the intention of all concerned to
improve the risk-based system over time.

For example, work

currently is proceeding on how interest rate and liquidity
risk might be included.
But to dwell on the accord's shortcomings really
misses the important points

We know the current system has

serious deficiencies, and the risk-based capital accord
clearly is an improvement

The risk-based accord

establishes the principle of requiring that a bank's»capital
ratio reflect its degree of risk.

The accord also

recognizes explicitly that off-balance sheet activities
impose risks on the bank and therefore deserve a capital
charge

In the risk-based accord a viable forum has been

created in which international cooperation on bank
regulatory matters can be designed and implemented

In an

increasingly interdependent world, there can be little doubt
that this represents important progress.

The accord

significantly reduces the competitive inequities to which
U.S

banks have been subject as American bank capital

standards rose relative to those in other nations.

Finally,

in the long run the accord may serve as a model for
international cooperation in regulating other aspects of
banking and even other financial intermediaries
The accumulation of adequate capital and the
successful implementation of a risk-based capital system
would certainly go far toward helping ensure the stability

-9of the system of depository institutions in the 1990s
However, the information revolution is changing the very
nature of financial intermediation in ways that, if certain
current statutory and regulatory policies are maintained, in
all likelihood will lead to a diminishing future role for
banks.

This, in turn, will make it difficult for banks to

obtain the capital they need
The key reform needed to respond to the
information revolution is, of course, repeal of the GlassSteagall separations of commercial and investment banking.
The provision of investment banking services, particularly
to corporate clients, is on the cutting edge of the
information revolution

Repeal of Glass-Steagall would

allow banking organizations to evolve with technology and
the market, and would provide real public benefits from
increased competition and the realization of possible
economies of scale and scope

Alternatively, maintenance of

the current environment will result in our nation incurring
unnecessary costs as banking organizations' specialized
resources are transferred into other activities or
businesses, not because of banks' unwillingness to compete
or innovate, but simply because of an inflexible statutory
and regulatory structure

In response to these concerns,

the Board has approved bank holding companies engaging in
certain hitherto ineligible securities activities in a
separate subsidiary of the holding company.

However, it

-10clearly is preferable that clarifying and comprehensive
legislation be enacted at the federal level.
While repeal of Glass-Steagall is certainly one of
the Board's highest priorities, it is worth recalling that
there are public policy concerns with such an action

These

concerns relate to preventing the transfer of increased risk
to the bank, to protecting impartiality in the granting of
credit, and to preventing extension of the safety net to
securities activities.

The desire to achieve these goals

has led the Board to support locating certain expanded
nonbanking activities, including expanded securities powers,
in separate subsidiaries of bank holding companies
Successful implementation of this strategy requires the
construction and maintenance of effective firewalls between
a bank and an affiliated securities firm

Thus, the Board

has required that firewalls be maintained as a condition of
regulatory approval for expanded securities activities, and
the Board has supported most of the firewall provisions of
the Financial Modernization Act passed by the United States
Senate

We believe the holding company approach is the best

available, can be tested in the "real world" of financial
institutions, and, if it proves as effective as we expect,
should serve as a foundation on which to build more
generally for the 1990s and beyond
I would emphasize that we must attempt to
coordinate our policies in such a way that each can be seen
as a piece of an integrated whole.

In particular, the

-11mcentives for financial institution owners and managers,
the public, and even regulators must be consistent within a
given policy and compatible with the incentives provided by
other regulatory actions.

It would be inefficient and

counterproductive, for example, if, on the one hand, we
attempted to increase shareholder discipline on bank holding
company risk-taking by increasing capital requirements,
while, on the other hand, we reduced lenders' discipline by
extending the federal safety net to holding company
debtholders.
The degree of policy coordination I am suggesting
is extremely difficult to achieve, in part because
incentives are often complex or subtle, and in part because
general policies are sometimes adopted in response to
specific events alone

Indeed, it may be impossible to

achieve complete consistency in some cases because the goals
of policy are themselves contradictory

However, unless we

make a strong effort to be consistent across market
participants and policies, we run the risk of achieving
little or no progress.
More adequate capital, risk-based capital, and
increased secuiities powers for bank holding companies would
provide a solid beginning for our efforts to ensure
financial stability

These reforms would not mean, however,

that no banks would fail, or that merger and acquisition
activity would cease.

Competitive pressures from

international banks, out-of-state domestic organizations,

-12new depository institutions, and nonbank financial firms
will continue and likely increase.

Various sectors of our

and the world economy inevitably will experience unexpected
changes in supply and demand

There will always be some

owners and managers whose fraudulent behavior or simple
incompetence puts their institutions at risk.
These arguments suggest other important policy
responses to our changed financial environment

First, the

timely closing of insolvent firms is vital if we are to
avoid the misallocations of credit, the distorted
competitive incentives, and the increased costs to the
deposit insurance funds that result when a failed
institution is allowed to operate with the public's money.
Second, the Federal Reserve supports efforts to
limit deposit insurance protection to depositors in the
insured intermediary, and not to extend protection to the
creditors of the parent holding company

Such efforts

correctly focus safety net protections on the depository
institution and provide holding company creditors a strong
incentive to control risk-taking at both the bank and
holding company level

Indeed, without a program that

places the risk where the profit potential is--the private
sector--it is questionable whether banking organizations
should be empowered to take on new risks

To do so would be

inconsistent with the broad policy of increased market
discipline that, as I have argued, must be part of a
responsible public policy that both permits banks to respond

-13to the changes in the financial environment and maintains
financial stability
Clearly, the policy responses that I could discuss
with you have not been exhausted.

I could have mentioned,

for example, continuing Federal Reserve efforts to control
risk in the payments mechanism, or the proposal of some
observers for market-value accounting at banking
organizations.

We shall always need accurate and up-to-date

monitoring of the risk position of individual institutions
through the supervisory process.
However, I believe that the responses I have
outlined today constitute the essential core of any set of
policies designed to deal with the financial landscape of
the 1990s

The future is inherently uncertain, and we

surely shall face new and unexpected challenges in the years
ahead

I believe that we can face the future with

confidence if we have the wisdom and the will to lay the
proper groundwork