The views expressed in this annual report
are expressly those of the author; they are not intended to represent
a formal position of the Federal Reserve System.
Most of us would agree that a safe
and sound banking system is a high priority. Similarly, many would
favor a system in which the taxpayer is not unduly exposed to the
costs of resolving mishaps in banking. And most would prefer an
efficient industry that serves its customers well.
Unfortunately, agreement on these broad objectives does not provide
much assistance in addressing some of the issues affecting banking.
The devil, or in this case the substance, really is in the detail.
Promotion of a more efficient banking system better able to meet
the needs of its customers suggests further deregulation and, many
bankers argue, greater flexibility in offering products and services.
But does such a step make sense in view of concerns about system
stability and taxpayer exposure?
Put another way, what other policy changes are required if further
deregulation is to occur? Granted that safety and soundness and
limited taxpayer exposure are both legitimate objectives, is the
balance between them proper or have we gone too far in assuring
stability, at the expense of the taxpayer? If so, how do we best
remedy the situation?
There are no simple answers to these questions; indeed, there
are meritorious but competing objectives for banking that must be
carefully balanced in formulating public policy. Proposals that
simply advocate one issue--the advantages of deregulation or the
need for an extensive safety net--implicitly favor one objective
over others and in so doing may result in a financial system that
is not only far from optimal but less satisfactory than the one
we have today.
One major policy objective is to promote efficient banking so that
bank customers are well-served. If this were the only objective,
the appropriate recommendation would be to remove the bulk of the
regulatory apparatus restraining banks, freeing them to compete
on the basis of product, service, location, and price, as do private
sector firms generally. Freedom of management to decide which products
and services to offer, how to price them, and where to locate geographically
is central to assuring that the customer is well-served. In general,
bankers will be better at identifying opportunities and taking advantage
of them than regulators, and the public will benefit to the extent
they do so. However, bank management is now precluded to varying
degrees from making these judgments, and thus it is virtually certain
that customers would gain from further deregulation of the industry.
However, these benefits may only be marginal because banks, after
all, are only one of a plethora of providers of financial services,
a group that includes, among others, insurance companies, investment
banks and brokerage firms, finance companies, credit unions, pensions
funds, and a range of foreign institutions. In general, competition
is fierce, both within banking and from non-bank financial services
firms encroaching on banks' traditional turf. Whatever this competition
may mean for banks, it is clear that customers already have a wide
range of options when seeking financial services.
Heightened competition is undoubtedly changing the face of banking
and is sometimes cited as an important reason to deregulate the
industry. There has been a tendency in recent years to depict banking
as an industry in decline, unable and perhaps unwilling to compete
effectively in lending to many of its traditional business customers.
Deregulation is viewed by some as central to the industry's survival.
To be sure, there are balance sheet data which suggest that commercial
banks have lost an appreciable amount of market share. But other
evidence leads to a different conclusion. Banks' off-balance sheet
activities have increased considerably, as the volume of asset securitization
has expanded and as banks have stepped up participation in the swap
markets, issued standby letters of credit, and so on. The growing
importance of these activities implies that balance sheets are at
best an imperfect and increasingly unreliable indicator of the role
of banks in financial transactions and in the economy generally.
Sector data from the gross domestic product accounts tell a similar
story, since they indicate that banking has grown more rapidly than
the economy as a whole over the past 40 years. Finally, bank capital
positions and earnings recently have been improving markedly, and
it is interesting to note that some of the most successful institutions
have concentrated on traditional banking businesses.
Even if the banking industry shrinks considerably at some point,
it is far from clear that policymakers should be alarmed by this
outcome. Public policy should focus on, among other things, the
interests of customers of financial services firms, and not on the
well-being of a particular class of institution. It would be foolhardy
to argue that banking should be preserved in its current form if
other institutions or markets perform banking functions as well
or better. Even if that were not the case, the costs of any such
preservation effort would have to be evaluated.
Irrespective of the strength of the case for deregulation, such
action would conflict with other objectives for banking, namely
concerns for a safe and sound banking system and limits on taxpayer
exposure as a result of disruptions in banking. Since it is not
clear at this time that these two objectives have been adequately
addressed, it would be premature, in our opinion, to grant banks
additional powers and permit them to engage in new activities. Deregulation
should await conclusive evidence that it will not unduly compromise
these other goals and, as discussed below, given the proliferation
of new regulations, it may well be very difficult to develop such
As an alternative to deregulation, consolidation of the banking
industry has at times been pushed on the grounds that it leads to
gains in efficiency or more-than-proportional cost savings and that
these results, in turn, will be passed to customers in the form
of better service. This conclusion is doubtful, to put it mildly,
because the evidence of many studies simply does not support the
position that there are meaningful economies of scale in banking
once an organization attains a fairly modest size.
From a narrow perspective, it is not of any great moment if there
are, or are not, significant economies of scale in banking. Larger
institutions will either compete effectively or they will not, and
management and shareholders will benefit accordingly. But if mergers
are approved by the regulatory agencies on the presumption of appreciable
gains in efficiency, which at least in part will be passed on to
customers, and this presumption is in fact in error, then public
policy has a stake in this issue, a stake that ought to put the
burden of proof on those who assert that considerable operational
efficiencies are gained through combinations of sizable banking
Indeed, much of the commentary surrounding the topic of consolidation
in banking is confused, and largely beside the point from a public
policy perspective. There, the principal issue remains antitrust,
which is intended to get directly to the heart of service to customers.
Will there be adequate competition after consolidation so that customers
are well- served? When regulatory approval is required, the agencies
involved have the responsibility to assure that adequate competition
will be sustained. Given the number and diversity of financial services
firms in the country, it is hard to see consolidation proceeding
so far and so fast as to appreciably alter the competitive landscape
at the national level. Local markets may be considerably different,
though, and there is reason to be concerned that some customers--small
and mid-size businesses and consumers, for example--may be disadvantaged
from "in-market" consolidation in particular.
Where antitrust concerns are not an issue, there would seem to
be no policy reason to oppose consolidation. Unfortunately, however,
with all of the state and federal regulation in place, it is virtually
impossible to get a reading on the scope and pace of consolidation
consistent with market forces, so policymakers are without this
guidance. Indeed, the situation may be worse if consolidation is
propelled by considerations that size confers higher management
compensation, continuing institutional independence, and the advantages
of the "too big to fail" umbrella. To the extent that these or similar
considerations go unrecognized, regulators may encourage consolidation,
thinking it a desirable response to market forces.
Banking Stability and Taxpayer Exposure
A second major policy objective, and one whose implications at times
conflict with those of the promotion of efficient banking, is to
assure a safe and sound banking industry. Commercial banks are special
institutions in that they offer demand deposits--accounts whose
balances are payable on demand at par--which form the basis of both
the electronic and paper-based payments system. Because of these
deposits' characteristics, banks cannot perfectly and profitably
maturity match such liabilities on the asset side of their balance
sheets, and thus banks can be subject to severe bouts of instability,
to depositor runs. Deposit insurance is clearly central to containing
such instability, for it assures the preponderance of depositors
that their funds are secure should the institution fail. Federal
Reserve discount window lending, for either short-term liquidity
purposes or to help resolve longer-term problem situations, constitutes
the second critical element of the safety net in place to promote
While there is little question that a safety net underpinning
banking is desirable, once one is in place bank activities must
be regulated and supervised to at least some extent in order to
offset the "moral hazard" problem. That is, with protection afforded
by the safety net of deposit insurance and the discount window,
depositors have little incentive to monitor the caliber of the institutions
with which they do business. Due to this lack of depositor discipline,
risk taking is priced too low in banking, and therefore too much
risk is systematically assumed. By taking greater risk, banks potentially
earn higher returns and, given the safety net, if the strategy fails
much of the cost may be borne by the taxpayer.
As the financial experience of the 1980s forcefully demonstrates,
a broad safety net not balanced by adequate depositor discipline
and effective supervision is costly to the taxpayer. Witness the
cost of honoring deposit insurance commitments in the savings and
loan industry. While problems in banking were not as severe, the
industry hardly distinguished itself. With hindsight, it is clear
that a large number of federally insured institutions took excessive
risk in dealings with developing countries; in lending to the energy,
agricultural, and commercial and residential real estate industries;
in support of highly leveraged transactions and through inordinate
interest rate risk.
In light of this experience, there is a compelling case to reexamine
the safety net and the resulting exposure of the taxpayer. To guarantee
a stable banking system, 100 percent deposit insurance might be
the answer, but protection of the taxpayer would require a regulatory
apparatus that could be very expensive and perhaps infeasible. Banks
might simply be unable to compete if regulations were too restrictive.
Even more important, it is far from certain that supervision and
regulation, no matter how intense, can fully replace market discipline
as a means of influencing safe and sound banking. We need to find
ways to restore balance between these objectives.
This is hardly an original observation. Congress recognized that
taxpayer exposure had risen to indefensible levels and, late in
1991, passed the Federal Deposit Insurance Corp. Improvement Act
(FDICIA). Although flawed, this legislation, in our opinion, is
in some ways a good deal better than is generally acknowledged.
At least implicitly, it recognizes that further deregulation of
banking is ill-advised until the issues of risk taking and taxpayer
exposure are addressed. And FDICIA attempts to control bank risk
taking, and thereby to reduce taxpayer exposure, through both extended
and more stringent supervision and regulation and increased reliance
on market or marketlike discipline, which narrows the scope of the
FDICIA requires, for example, risk-sensitive deposit insurance
premiums, limits on discount window lending to troubled institutions,
inter-bank credit limits, and constraints on brokered deposits.
Most significantly, it substantially reduces deposit insurance coverage
relative to recent practice. Under FDICIA, with only very limited
potential exceptions, deposits over $100,000 are completely uninsured,
and an individual's ability to maintain multiple insured accounts
at any one institution is restricted. The FDIC is a good deal more
constrained in extending insurance coverage than it recently has
been, as is the Federal Reserve constrained in its provision of
discount window credit. Implemented as intended, this legislation
should go some meaningful distance to achieve the greater degree
of market discipline essential to reduce moral hazard in banking,
which in turn should lead to decreased risk taking, healthier institutions,
and less taxpayer exposure.
One reservation about this aspect of FDICIA centers on the issue
of too big to fail, the practice of protecting all depositors, including
the uninsured, of large banks for reasons of systemic instability.
Although FDICIA has provisions to discourage the FDIC and the Federal
Reserve from treating a bank as too big to fail, there is still
the latitude to do so. To the extent that too big to fail persists,
or market participants believe that it does, the largest banks will
not be subject to adequate market discipline. To the extent this
is true, such banks ought to be subject to more stringent supervision
and regulation than others, if taxpayer exposure is to be limited.
The intensified supervision and regulation of FDICIA takes several
forms. It emphasizes the adequacy of bank capital, limiting significantly
the activities and opportunities of undercapitalized institutions
and calling for prompt supervisory intervention in the case of weak
banks. FDICIA also requires regulators to prescribe operational
and managerial standards, allows regulators to impose limits on
executive compensation, requires outside audits, and imposes additional
limits on loans to insiders. In some instances, these provisions
appear intrusive and costly relative to the potential benefits that
might be achieved in terms of safety and soundness.
One troubling aspect about this side of FDICIA is the way in which
it changes the role of the regulator. On the one hand, it sharply
curtails the discretion available to regulatory authorities in addressing
supervisory problems while, on the other, in some cases it almost
substitutes the regulator for bank management. There is not only
a broad array of new regulations under FDICIA, but also considerably
less discretion permitted in the application of regulations to particular
facts and circumstances. The premise, apparently embodied in FDICIA,
that "cookbook" supervision and regulation is essential to limit
the cost of moral hazard to the taxpayer is questionable. Indeed,
its effect may be perverse. The "one size fits all" approach that
the regulatory agencies have taken to implement FDICIA's capital-based
prompt corrective action framework seriously reduces its relevance
for the vast majority of banks.
Another important problem with FDICIA is that it gives little
if any weight to the objective of enhanced efficiency and customer
service. Indeed, FDICIA threatens to compromise this objective by
curtailing management's latitude to make business decisions. To
the extent this happens, customers will not be as well-served by
banks as they could be. Moreover, while FDICIA's constraints on
the safety net are a positive step, it will be difficult to judge
the effectiveness of those constraints because they are coupled
with tightened regulatory requirements and are implemented (approximately)
simultaneously. Thus, we will not know when and if it is safe to
deregulate, because we will not have a clear reading on the consequences
of increased market discipline for stability and for taxpayer exposure.
We have to acknowledge at the outset that within banking policy
are a number of legitimate but competing objectives. The appropriate
course is not to declare one objective preeminent and pursue it
single-mindedly. Depending on the objective selected, we could have
a highly regulated banking system unable to meet the needs of its
customers effectively, or an increasingly risk-prone system that
could prove expensive to the taxpayer. The responsibility of public
policy is to appropriately order and balance these objectives so
that progress can ultimately be made on all fronts. This strategy
would suggest, in our judgment, dealing first with the scope of
the safety net and the issue of taxpayer exposure. After these issues
are resolved, policy can move to the question of banking deregulation.
We are convinced that it would be ill-advised to grant banks expanded
powers before we are sure the incentives are corrected that encourage
excessive risk taking. FDICIA makes a start in this direction, but
unfortunately its multitude of provisions will make it difficult
to determine if and when deregulation is appropriate. In giving
short shrift to the objective of efficiency and customer service,
FDICIA does not represent the balanced approach we believe appropriate.
Future policy, and subsequent legislation, should restore balance
by more specifically emphasizing market discipline and by removing
regulations that unduly limit management latitude for normal business
decisions and that make the job of the regulator overly intrusive.