MONEY and BANKING PAPERS FULL GRAPHICS

 


Bank Regulation


by  Tushar Satish  Modi
 

 

            Before the advent of the Federal Deposit Insurance Corporation (FDIC) in 1933 and the general conception of government safety nets, the United States banking industry was quite different than it is today.  Depositors assumed substantial default risk and even the slightest changes in consumer confidence could result in complete turmoil within the banking world.  In addition, bank managers had almost complete discretion over operations.  However, today the financial system is among the most heavily government- regulated sectors of the U.S. economy.  This drastic change in public policy resulted directly from the industry’s numerous pre-regulatory failures and major disruptions that produced severe economic and social hardship.  Although the regulated United States banking industry has not fallen victim to bank crises since the Great Depression, this relative healthiness of the industry comes only with substantial costs.  Many laws and regulations have restricted banking activity, precipitating a relative decline in the importance of the traditional banking sector.  In addition, the introduction of money market mutual funds, commercial paper, junk bonds, and securitization into the financial industry created more lucrative alternatives that further reduced the role of traditional banking.  In an effort to survive and maintain profitability under the changing economic environment, banks attempted to evade regulation through innovation and a process known as loophole mining.  Recently, the same concerns that led governments to regulate domestic banks, such as uncertainty and instability, are pressuring policy makers to harmonize banking regulation internationally, while the limitations and problems encountered by domestic regulation have caused such proposals to be met with much controversy.  In addition, the current unregulated globalization of the economy is increasing prosperity and economic welfare worldwide.  Differences in banking regulations across borders permit the most efficient channeling of funds from lenders to borrowers, leading to increased investment and thus increased GDP.  Therefore it is imperative that policy makers prudently evaluate the possible consequences and benefits of harmonized banking regulations, as demonstrated by similar regulations instituted domestically, before any such endeavor is embarked upon.

 

During the 1930s, the most prominent reason for U.S. banking regulation was to prevent bank panics and more economic disaster like those that had been experienced during the Great Depression.  Later deregulation and financial innovation in industrialized countries during the 1980s eroded banks monopoly power, thus weakening their banking systems and seeming to embody the fears of post-Depression policy makers who instituted regulation in the first place.  Fear that individual bank failures could spread across international borders creates pressure to harmonize bank regulation worldwide.  One advocate suggests that universal banking, at least for industrialized countries with internationally active banks, would “level the playing field” by eliminating competitive advantages created by government subsidies.  Although this is a valid point, one of the major driving forces behind the globalization of the banking world is the ability of banks to take advantage of differences in regulations.  Additionally, the reduction and elimination of trade barriers has led to increased capital mobility even without international regulation.  In fact, the difference between the Eurodollar interest rate and the U.S. certificate of deposit interest rate has grown closer to zero as international capital mobility increases.  The disadvantages of regulation in the international banking system are very similar to the disadvantages present in domestic markets.  Not only does the presence of safety nets cost the government substantially, but they also result in moral hazard.  Since banks realize that their deposits are secured, incentives to assume riskier projects arise, increasing the possibility for frequent and costly failed investments.  Despite this, many critics of the current system feel that a banking crisis is pending unless international regulation is enforced.  This belief stems from the theory of portfolio diversification, which states that people trade assets internationally to reduce risk by diversification.  However, since evidence suggests that international assets are not well diversified it is rational to assume that the risks of unregulated international trade increase with this lack of diversification, possibly setting the world economy up for a collapse similar to that suffered in the U.S. during the Great Depression.  The relative health of the U.S. banking system since the 1930s is possibly the most convincing reason to adopt international regulations.  Although the regulations obviously come with costs, they have prevented major bank crises within the U.S for over seven decades, and it is believed by many that similar international regulations would create similar international economic stability.

 

Advances in technology and communications during the 20th century have simultaneously decreased the cost of banking services and increased the demand for such services.  In response, banks

have expanded both domestically and internationally, across borders.  This wave of globalization, driven by the profit motive, is certainly not unique to the banking industry.  Many financial institutions have also developed new products to satisfy both their own and their customers' needs, in order to remain competitive.   This wave of innovation, caused by a change in the financial environment, presents newer challenges for policy makers.  For example, the creation of the Glass-Steagall act in 1933, in response to the new financial institutions developed as a reaction to regulation, clearly differentiated the role of commercial banks and other financial services in the United States.  The act prohibited commercial banks from underwriting securities or engaging in brokerage activities.  Moreover, this regulation also extended to investment banks and insurance companies by disallowing them to engage in commercial banking.  Together these provisions served to protect banks from competition.  However, the introduction of money market mutual funds allowed brokerage firms to engage in the banking business of issuing deposits.  Furthermore, the Federal Reserve used a loophole in section 20 of the Glass-Steagall Act to allow holding companies, companies than own one or more banks, to underwrite securities.  These instances were important precedents that led to increased cases of loophole mining, a process that arose in response to regulation that is described by economist Edward Kane as the process of scrutinizing sections of regulations until methods of avoiding the regulation are found, innovation, and the repeal of the Glass-Steagall Act within the US.  An international version of the Glass-Steagall Act, or a similar plan for regulation, could also simply lead to the processes of loophole mining and innovation, increasing banks' profitability but failing to enforce the regulation procedures that it was created to protect.   

 

The connection between government regulation and innovation stems from firms’ desires to avoid regulations that restrict their ability to earn profits.  Before describing the innovative tools that banks and financial institutions use to evade regulations, it is important to define which regulations are the most relevant.  While many different regulations hinder the ability of banks to maximize profits, two sets of regulations apparently afflict banks’ profitability the most:  reserve requirements mandating that banks keep a certain percentage of their deposits as reserves, and restrictions on interest payments that can be paid on demand deposits. 

The first factor, reserve requirements, effectively acts as a tax on deposits since the Federal Reserve does not pay interest on reserves.  Thus, the cost of reserves is the interest rate that banks could have earned on these reserves.  Although these reserve requirements may reduce bank profitability, they provide liquidity to banks in case of a substantial sudden withdrawal.  The main function of reserve requirements is not to increase the Federal Reserve’s control over the money supply, but to provide banks with liquidity cushions that can overcome small recessions and can prevent economic disaster.  In fact, many banks choose to keep excess reserves on hand to further mitigate the risk of insolvency.   Therefore, the profitability sacrifices that banks make due to reserve requirements can be justified by the protection that reserve requirements bring to the economy.  Nevertheless, during periods of higher interest rates and inflation, banks do suffer greater losses, and usually seek international alternatives and other loopholes.

For example, Congress introduced Regulation Q in the US in 1933, which restricted interest payments on demand deposits, in an attempt to protect against bank failures.  This was accomplished by reducing the need for banks to invest in risky assets in order to finance high interest payments on deposits.  Since banks only had to pay very little interest, they were able to increase their profits by charging more for interest on loans than the interest that they paid out, and so any additional necessary investments could be low-risk.  Until 1980, Regulation Q additionally completely prohibited the payment of interest on checking account deposits.  While it would seem that banks would benefit from not having to pay interest on checking account deposits, consumers were negatively affected by this regulation and so began to look elsewhere for places to invest their money where they would receive high interest payments.  This simply motivated banks to search for ways to get around the regulations so that they would not lose their customers.  Currently, Regulation Q allows the Federal Reserve to set limits on the maximum interest payments allowed on these time deposit accounts.  Evidence suggests that Regulation Q may result in substantial losses to commercial banks even under stable economic conditions.  In situations with a typical federal funds rate, which is the interest rate on overnight loans the Federal Reserve charges banks, the banking industry’s annual profit loss approximately amounts to 0.5% to 1% of total nationwide demand deposits, or $2.5 billion dollars.  During times of rising inflation and interest rates, the burden is magnified and creates even more urgency and desire to skirt the regulation.  In fact, between the 1960s and 1980s, rising inflation and interest rates coincided with a more rapid pace of financial innovation, signifying a more intense effort to offset the adverse effects of Regulation Q.   

 

During the 1960s when inflation and interest rates were high, banks suffered an increased tax on deposits held as reserves.  The tax burden was (i x rd) the interest rate multiplied by the dollar amount of deposits held in reserves.  The burden rose proportionally with the interest rates.  In addition, the high interest rates greatly exceeded the interest rate ceilings set through Regulation Q.  This caused many investors to withdraw their funds in search of higher-yielding securities.  Consequently, banks hastily mined loopholes and created Eurocurrencies, which are foreign currencies deposited in banks abroad.  This major innovation is not susceptible to regulations such as reserve requirements and other capital controls, since domestic regulations cannot be applied internationally.  Since banks abroad were not subject to reserve requirements and they could avoid the interest rate ceilings set by Regulation Q, Eurocurrencies allowed banks to loan out a greater fraction of their deposits, resulting in greater profits.  Even though the introduction of Eurocurrencies occurred in the 1950s, they are still among the most successful ways for banks to evade domestic regulations today.  In fact, the current Eurodollar market (deposits in accounts in the United States transferred to banks abroad) has an outstanding balance of over $5 trillion, making it one of the most important financial markets in the world.  Ironically, the U.S. Eurocurrency market is not very large since it applies fairly uniform regulations to all domestic deposits, regardless of currency.  While Eurocurrencies initially arose as a market response to regulations and political prohibitions, their usage now serves even more valuable purposes.  For example, the Latin American population predominantly holds dollars as a way of curbing inflation and stabilizing their economy.  Therefore what began as simple loophole mining in order to increase bank profits resulted in a much more substantial and invaluable positive externality.  Many other innovations also arose as a result of loophole mining, such as commercial paper and negotiable order withdrawals (NOW), producing effects on the banking industry similar to those produced by Eurocurrencies.  There is no reason to believe that international reserve requirements and international restrictions on interest payments would not produce similar, if not identical, responses on a global level

Even if all policy makers agreed that there is need for the international regulation of the banking system, it would be very difficult to formulate effective regulations for many reasons.  First of all, it is not possible under current rules and regulations to impose reserve requirements on foreign branches of banks, as they are not under the jurisdiction of the governments of their home countries.  Second, under international regulation it may not be clear who the lender of last resort would be in the unfortunate case of bank failure.  Consider a Spanish subsidiary of a British bank where the majority of assets are denominated in dollars.  Who would be the regulator and in the case of its failure, who would be the lender of last resort?  It could be the Federal Reserve, the Spanish National Bank, or the Bank of London.  In order to successfully implement international banking regulations, all countries involved must cooperate, and the answers to questions such as these must be determined.   

 

Despite all the difficulties involved in regulating the banking industry, it would be beneficial if policy makers could cooperate in successfully implementing some form of international banking regulation.  The primary function of banking regulation is to protect consumers and although many banks try to avoid regulations, regulations are very necessary.  In the absence of regulations, even the slightest sign of bank troubles could lead to a bank panic, as evidenced by pre-regulated U.S. banking history.  The question, then, is not whether or not to regulate the international banking world, but rather how much regulation is appropriate and possible.  Deposit insurance, some type of government safety net for consumer protection, and disclosure requirements are absolute necessities.  Policy makers can then decide how to install other regulations such as restrictions on bank asset holdings, capital requirements, and bank examinations. 

The design of the transnational regulations was delegated to the Basel Committee, composed of representatives of central banks from 11 developed countries and located in Basel, Switzerland.  It has experienced some success, but it still has a long way to go.  Its first endeavor focused on capital relative to the risk exposure of individual banks.  In 1988, the committee set a common standard in regards to capital adequacy.  Each member bank had to maintain a level of capital, or net worth (assets-liabilities) at least 8% of its total risk-weighted assets.  Although the Basel Committee continues to work to formulate policies, their task is not easy and the primary current concern is safety.  The Committee must proceed cautiously because regulations have unintended as well as intended effects and the costs of some of the unintended effects may offset the benefits of the intended effects.  For example, the government guarantees to enhance safety but in doing so, it encourages excessive risk taking by banks and excessive tolerance by regulators.  It is also important to remember that even if the Basel Committee agrees on regulations that detract from banks’ profitability, economic analysis predicts that banks will mine loopholes and will somehow avoid them, leading to innovation and consequently increased overall welfare.  Although regulation may not function exactly as intended, domestic experience demonstrates that regulation is invaluable to stability and security, and even the costs produced by such regulations merely present hurdles that the banking industry has become adept at overcoming.  Only by facing new challenges do banks produce new solutions, thus ultimately increasing their own profitability and the well being of consumers.    

 

References:

Benston, George J. and George G. Kaufman, “The appropriate Role of Bank Regulation,”

Economic Journal, May 1996, pp. 688-697

University of California Davis, “Capital Market Regulation,” July 1998

                http://www.econ.ucdavis.edu/faculty/bergin/law/law3.pdf

 

Carfang, Anthony, “Reg Q’s Repeal Would Mean a Chance to Stop Deposit Drain,”

            American Banker: The Financial Services Daily.

 

Equity Analytics, LTD.  “Reserve Requirements of the Federal Reserve,”

            http://www.e-analytics.com/bonds/fed18.htm.       

Jones, D., 'Emerging Problems with the Accord: Regulatory Capital Arbitrage', Journal of Banking and Finance, Vol.24, 2000, pp.35-58.

Kaufman, George G, “International Banking Regulation,” Loyola University; July 2002.

Mishkin, Frederic S,  The economics of Money, Banking, and Financial Markets. 

            Addison Wesley Publishing, 2003, pp. 211-311.

 

Treasury Strategies Inc,. “Regulation Q Summary and Update.”

            http://www.treasurystrat.com/financial/downloads/regQupdate.pdf.

 

 

 

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