Dr Ewa MiklaszewskaCracow University of EconomicsDept. of Financee-mail: uumiklas@cyf-kr.edu.pl

The Wolpertinger Meeting, Siena:

Market Discipline versus Public Regulator:A Search for an Adequate Regulatory Regime

Introduction

International financial markets are govern by the interplay between public regulations, private regulations and the environmental changes. Thus, the paper concentrates on the question to what extend the evolution of market and regulatory regimes has been inducing banks to a more socially desirable behaviour and what are the regulatory lessons for Poland from the global trends. Does the tendency to replace past strategy of mounting public regulatory requirements by giving more weight to banks’ self-regulation or private regulations lead to a more efficient, welfare-maximising framework? Does it lead to less conflicts of interests and more ethical financial environment. To answer these questions, the paper looks first at the investment bank, where conflict of interests is currently a key issue, and then analyses the problem from a commercial and universal bank perspective.

1. „Importance of Being Good”

Recently in financial literature we can observe a discussion on ethics, stimulated by the Enron scandal. The Banker in April (2002) opens with a paper entitled: „Importance of being good” arguing that unethical banks will not survive in today competitive environment and that financial sector must adhere to a strict code of conduct. The Economist (May 4, 2002, p. 75) discusses the results of SEC investigation into conflicts of interests in the US financial market. As a result, first public apologies for ethical breaches are given by well known banks, such as Merrill Lynch, which has been accused of misleading advice given by its analysts. As a reaction to the crisis, some firms are considering separating research from investment activities, others like Morgan Stanley have decided to abandon issuing recommendation (buy, hold, sell) altogether. Soon after abolition of Glass-Steagall Act, which separated lending from capital market activities (replaced in 1999 in the US by Financial Modernisation Act, known as Gramm-Leach-Bliley Act), similar regulatory proposals are being suggested, such as separating auditing from consulting, or research from trading, all in order to avoid the biggest plaque in investment banking: the conflict of interests.

For an investment bank, unethical behaviour constitutes in a long run a major threat, as the investment banking business is based mostly on reputation. There are many instances from the past to illustrate it, such as:- the collapse of Drexel Burnham Lambert in 1989,- Salomon Brothers scandal in 1990-91,- Bankers Trust problem with corporate culture in the mid 1990s,- currently, Arthur Andersen scandal with the handling of the Enron case.

Drexel Burnham Lambert, instrumental for developing a junk-bond market and starting the LBOs revolution in the 1980s, end up in bankruptcy in 1989, soon after its creator Michael Milken was sentenced guilty for fraud (Santomero, Babbel 1997).

The scandal of Salomon Brothers, a prime investment bank, cheating on Treasury paper auctions in the early 1990s was probably the first major scandal involving a major investment bank. After investigation, the bank admitted several illegal bids in auctions for government securities in 1990 and 1991, in order to monopolise the market, force up prices and squeeze the competition (Walter, Smith 1999). As a result, the bank had to change its entire management and culture, compensate the investors and the Treasury and in the long rung the blow to its reputation was hardly reparable (including 30% drop in its share price after reviling the scandal). The firm was saved by the new director, Warren Buffett, but 80 years of reputation for integrity and fair dealing were lost. In the long run, Salomon did not survive as in independent firm and today is a part of Citigroup investment arm: Salomon Smith Barney. A side effect of the Salomon scandal was that it convinced the major US business schools to introduce business ethics as an important teaching subject.

Bankers Trust, which in the 1980s transformed itself from a mediocre commercial bank into a prime-rated, creative global wholesale institution, discovers the early 1990s that the transformation was probably too fast, and its culture too aggressive. In 1994 the bank was accused by clients of misleading them on the nature of risk of financial leveraged instruments. It lost in court, was fined by SEC and warned of lack of transparency by other regulators. As a consequence, the bank has lost its public image as a market leader (Euromoney, April 1995). In 1999, it was sold to Deutsche Bank.

Recently, Arthur Andersen will probably cease to exist as an independent firm, as a consequence of its handling of the Enron case. Enron, until last year the world’s largest energy-trading company, had been prized by financial analysts and stock market for its aggressive strategy, based on the new opportunities in the deregulated energy market. Beyond its core natural gas business, it tried to enter electricity and water markets, and even hedge London weather. „Creative accounting” and lack of transparency undermined its credibility and in October 2001 its shares and credit rating plunged to a junk status. In December 2001 it filled for bankruptcy and many of its employees lost their savings in addition to their jobs. Andersen, Enron’s accountant, which has been accused of negligent auditing, distorted tons of papers related to Enron case. The public opinion was shocked at the way how auditors, banks, rating agencies and regulators ignored the deterioration of Enron returns. Neither the sophisticated capital market analysts, nor Enron banks: Citigroup and J.P. Morgan Chase, nor even the outsiders paid to monitor the firm did alert the market

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until it was too late (the Economist, Jan 11,2002). The behaviour of Andersen, Enron’s auditor, was particularly shocking, displaying the instances of incompetence and corruption. It has been approving Enron’s accounts despite concerns about the transparency and then tried to undermine the public investigation. Andersen’s behaviour may be partially explained by the conflict of interest: in 2001, Enron paid them $25m. for audit and $27m. for consulting. Enron has also been a generous political contributor .

The examples discussed above were the clear instances of investment banks or firms which were unethical and unsuccessful and as a consequence lost their reputation, market and sometimes even existence. Prime firms live in the spotlights hence any ethical problem has an immediate consequence. For unethical but successful deals, the lessons are less straightforward. For commercial banking, the direct links between reputation, social responsibility (ethics) and financial results are even more complex.

2. Strategic Evolution in Commercial Banking

Looking at the issue of ethical dealings, or social responsibility, from a commercial bank perspective, the message is complex. For years, those banks have enjoyed monopolistic position on the financial market and have traditionally been accused of being big and powerful, making excessive profits or ignoring social needs. Typical complaints against commercial banks could be categorised under 10 main headings:

- the big banks have too much power,- their profits are excessive,- their charges are extortionate,- they have not lent readily enough,- they have rent too freely,- they are too big,- there is scant sympathy for the needs of smaller business,- human interest has disappeared from our dealings,- there is too much red tape in the administration which is out of touch with local feeling and local needs,- bank buildings are too extravagant.

Source: "Banking Ain't Fun Any More”The Institute of Bankers' Presidential Address of Mr F.L. Bland (1933).1

These accusations, formulated in 1933 and applicable for the following half the century, today no longer seem adequate and the transformation of the banking industry after the deregulation of the 1980s has been well documented. Competition in the financial market reduced dramatically the profit margins (table 1) and forced banks to reshape their strategies, giving rise to the assertion that traditional bank is dead (Rajan 1998). Deregulation of financial markets, technological progress and globalisation of financial

1 Quoted by B. Pearse (1993) Towards 2000: Challenges and Imperatives. London: The Institute of Bankers, Presidential Adress.

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services have changed the economic powers and position of the banking industry (table 2). In consequence, the strategic behaviour of banks has altered, resulting in a focus on efficiency, rather than on extracting monopolistic rent or fighting for regulatory capture (Vives 2000; Gordon 1998).

Table 1: Interest Margins of Commercial Banks: Average margin on demand deposits (%)

(Current short-term rate minus interest paid on deposits)

Country 1980-85 1987-92 1994-95 1996-98Belgium 11.2 8.7 5 3Denmark 16.2 9.0 NA NAFrance 11.7 9.7 6.1 3.5Germany 6.5 7.2 4.8 3.4Spain 14.5 6.0 3.6 0.6The UK 10.8 7.0 3.6 3.6

Source: J.Dermine (1999).

Table 2: Share of Assets of Financial Institutions in the US (% of total)

1910 1948 1960 1980 1993Commercial banks 65% 56% 38% 35% 25%Thrift institutions 15% 12% 20% 21% 9%Insurance companies 17% 24% 24% 16% 17%Investment companies Na 1% 3% 4% 15%Pension funds 0% 3% 10% 17% 24%Other 3% 4% 5% 7% 9%

Source: H. Rose (1998), p. 369.

3. Regulatory Response to the Changes in Banking Markets

Banks have strong externalities on the economy and in the last instance a public regulatory organ pays for the banking crises or problems in large banks. Banking crises bring damage to employment, income and economic growth. The efforts to limit banking risk are therefore more than justified and the stability of the financial system has always been an important macroeconomic policy goal and regulatory priority. The main objective of banking regulation is stability, trust and panic avoidance. For years, public regulatory organs have performed those functions fairly well in the stable international environment. Most of systemic regulations was introduced in the '30s, in response to massive bank failures. These acts, together with deposit protection, ensured long-term stability of the

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banking market. Market efficiency, transparency and rights of the investors were scarified for the sake of the safety and stability of the banking industry. Consequently, a failure of a bank constituted to a large extent a failure of the regulatory and supervisory organ, which encouraged a moral hazard behaviour. The typical safety net for crisis prevention is summarised below:

Table 5: Typical Crisis Prevention Safety Net

Evolution of Financial Crisis Regulatory Safety NetBank assumes excessive risk(economic expansion)

Should be prevented by prudential supervision

Bank's solvency in doubt Bank should be closed before this happens

Run on bank Should be prevented by deposit insurance

Abrupt closure of bank,losses to depositors

Should be prevented by tender of last resort

Runs on “similar” banks Should be prevented by deposit insurance

Liquidity- related failures Should be prevented by lender of last resort

Contraction of the reserve base Should be prevented by monetary authority

Moral hazard effect Incentive to take excessive risk

Licensing authority should bar imprudent,incompetent and dishonest banks

Source: R.Smith and I.Walter (1990) Global Financial Services. New York: Harper Business, p.705.

However, the operation of the safety net created problems of inefficiency and fairness, i.e. how to distinguish between institutions that is too big to fail and those which are too small to save? The authorities did not intervene promptly when there was a danger of insolvency, but usually when it was too late. They also did not prevent herding behaviour, described by J.M. Keynes in 1931 in the following way:

" a sound banker is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows so that no one can really blame him"2.

The regulations have contributed to the moral hazard problem: bank managers, knowing that they are likely to be bailed out, behave in a less risk-averse manner. These are the prices paid for greater financial stability. Moreover, the safety net has been in many cases too successful in protecting depositors, who therefore did not have the incentive to monitor and discipline banks. Consequently, depositors frequently do not know exactly about the

2 Quoted in R.Herring (1998), p.387.

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extent of insurance coverage, assuming that the government would always bail out large banks in the last resort. Finally, the regulators and authorities may have the same bias as the bankers. They restrict diversity, making banks more vulnerable.

4. Too big to fail

Recent wave of mergers and acquisitions (M&A) poses new regulatory challenges. In Europe, the number of depository institution has declined from 12000 to 9000 between 1985-97 (Dermine 2000), and in the US from 12000 to 7000 between 1979-97 (Danthine 1999). Concentration has been particularly dramatic in the mega-banking segment: in the US, banks with assets above $100 bn increased their market share from 9% to 19% (Rajan 1998) and recent mega transactions like mergers between Deutsche Bank and Bankers Trust, Swiss Bank Corporation and UBS, Banco Santander and BCH or Citibank and Travelers, all involving assets around $800 bn, are cases in the point (Walter 1999). Among the largest global banks, the top ten exceeds assets of $500 bn (table 3).

Table 3: The World’s Largest Banks by Assets, billions of dollars

Bank Assets in 1999

Deutsche Bank, Frankfurt 845

Citigroup, New York 717

BNP Paribas, Paris 702

Bank of Tokyo-Mitsubishi, Tokyo 697

Bank of America, Charlotte N.C. 632

UBS, Zurich 614

HSBC Holdings, London 569

Fuji Bank, Tokyo 552

Sumitomo Bank, Osaka 509

Bayerische Hypo Vereinsbank, Munich 505

Source: American Banker online

Mergers and acquisitions have been very actively sought, although the empirical evidence on economies of scales and scope in banking are controversial and non-conclusive. Many studies proved that economies of scale have limited relevance in banking and are being exhausted in the middle range scale - for assets below $100 millions. Above $5 bn are not relevant at all (Walter 1999). On one hand, merging banks believe in merger-related cuts in operational costs or in increase in efficiency due to synergy, know-how and technological advance. On the other hand, economic studies of past mergers show that much of expected merger-related efficiency have not materialised and gains were mainly related to the reduction in employment (Scherer 1998), which also rises some ethical considerations.

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Studies in so called „happiness research” found that that the strongest influence on happiness is employment. Work is sometimes considered a burden, but being unemployed, even when receiving the same income as when employed, decreases significantly people’s wellbeing. Unemployment seem to be to a large extend involuntary, and happiness depends strongly on low inflation and employment. Income promotes happiness only till some point, and in richer countries the relationship is irrelevant (Frey, Stutzer, 2001). Hence, if merger-related gains are mainly due to cutting employment, they lead to a suboptimal social structure.

Regulatory authorities in the major countries were active in safeguarding competitive structure and in the past actively prevented overconcentration. However, recently the preventive regulatory actions, particularly against megamergers, have been rare. The newly created global megabanks may have significant impact on domestic macroeconomic trends and public wellbeing, both by their economic impact, lobbying power or becoming too big to fail. The biggest banks in some European countries, such as Switzerland or Holland, have equity capital equal to 5-8% of their GDP. In case of failure, the costs of rescuing them would constitute a sum difficult to comprehend. Polish main banks are still far from posing this threat, having capital in the range of 0.5% of GDP. However, consolidation processes among top banks have only started.

Table 4: Concentration in the Banking Markets

Country/bank Equity(book value; billions of Euro)

Bank equity/GDP

The UK:

HSBC (UK)

RBS-Natwest

Barclays

29

16

13

2.1%

1%

1%

France:

Credit Agricole

BNP-Paribas

Societe Generale

26

23

12.5

1.8%

1.6%

0.9%

Switzerland:

UBS

Credit Suisse

20.5

17.5

8%

6.9%

Germany:

Deutsche Bank

Bayerische Hypo

19

15

0.9%

0.7%

7

Dresdner 13 0.6%

Holland:

ABN Amro

Rabobank

ING Bank

17

15

13

5%

4%

3%

Spain:

Santander-SCH 13 2.6%

Belgium:

Fortis

KBC

7

5

3%

2.3%

The US:

Bank of America

Citigroup

47

41

0.5%

0.5%

Poland:

PeKaO S.A.

Bank Handlowy

PKO-PB S.A.

1

0.8

0.7

0.6%

0.5%

0.4%Source: Data based on Dermine (2000); for Poland, author’s estimates.

5. Evolution towards Private Banking Regulations (Basel II)

The deregulation of banking services in the 1980s has resulted in much poorer record of the public regulatory organs (i.e. banking crises in the US in the ‘80s or in Asia in the ‘90s). The regulatory organs turned out to be reluctant in closing insolvent banks, particularly the large ones, and prone to industry capture. Public regulations have bias towards protecting the industry and not the market (Ryan 1998). Moreover, instances from relatively unregulated markets showed that regulation alone do not ensure stability. Unregulated euromarket has been functioning for the last 30 years as a multi-trillion dollar market without a major incident, similarly stock exchanges and OTC-markets are mostly self-regulatory rather than externally regulated and function smoothly, as high standards and credibility are important for their profits (Kroszner 1998).

Capital market regulations focus on protecting investors’ interests rather than the stability of the institutions. They are based on both public and private regulatory rules. In private regulatory system (such as closed clubs or private rating agencies) the question of credibility is largely preventing the possibility of industry capture and unethical deals (Kroszner 1999). Issues such as transparency of the market, fair treatment of investors, fair

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market competition and open market access should then constitute a regulatory priority also in the banking industry. Consequently, deregulation and globalisation of financial markets have forced banks and the regulators to rethink what constitutes the basis for the competitive advantage of the banking industry. Bank efficiency has emerged as an important policy variable also from a regulatory point of view. Responding to those pressures, regulatory thinking has been evolving towards adoption of some of the capital market's attitudes and considerations. The current regulatory reform, so called Basel II, aims at introducing better risk management practices. It is centred on giving more weight to banks’ self-regulation and private regulation (such as that of rating agencies), as opposed to mounting public regulatory requirements, particularly for large global banks.

Basel II is a new version of the 1988 Capital Accord which serves as the basic capital requirement for banks around the globe. The so called capital adequacy ratio requires banks to hold capital equal 8% of their risk-weighted assets. Although the Basle Committee on Banking Supervision, established by the regulators from G-10 countries under the auspices of the Bank for International Settlements, has no supranational authority, more than 100 countries have adopted the standards set in 1988 accord. The accord served international community well, however after the deregulation it has become increasingly less adequate for risk management in the global and very competitive international framework. In the new framework large banks will be able to use internally generated models such as VAR or IBR systems, to determine the adequate capital base. For other banks the importance of private regulations (rating) will dramatically increase. Hence, private rating or self-regulation will replace the past tendency to mount public regulatory requirements, making the system more transparent and efficient.

As for the new proposals, banks will be able to choose among three methods for determining the risk weights on their credit assets (The McKinsey, 2001).

- a standardised approach, where risk weight will depend on the type of borrower for whom the rating is given by private, independent agencies such as Moody’s and S&P. For example, loan to AAA-rated corporation will receive a 20% risk weight and require 1.6 cent of capital for each dollar lend, as opposed to current 100% weight (8 cents). A loan to a BBB-rated sovereign, such as Poland, would receive a 50% risk weight, as opposed to 0% today.

- two approaches based on internal credit-rating systems (IRB): foundation and advanced.

Under foundation IRB approach banks will calculate their capital requirements using internal estimates of default probabilities together with regulator-assigned values. Under the advanced IRB, few selected banks will be able to calculate capital by using their own estimates for key variables

Basel II also proposes capital requirements for banks’ operational risks. The banks will be required to disclose the composition of their credit portfolios by risk ratings and banks using IBR approach will have to publish their individual risk parameters (The McKinsey, 2001).

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6. Bank Regulation as an Outcome of Interest Groups’ Battle

The regulatory outcomes can also be largely explain as a result of competition among the main interest groups: large banks and small banks, commercial, investment and insurance firms and the government and public agencies. According to R. Kroszner, main forces behind the regulatory change are:- public interests: correction of market failures and prevention of externalities, even at

the expense of welfare-maximisation,- private interests: well organised groups lobbying for rules which benefit them,- dominant ideology (like Glass-Steagall Act in 1933, based on belief that large banks

were responsible for overheating the economy of late 1920s),- existing political and institutional set-up (including accountability and transparency of

public institutions, tax consideration, etc.)

Public interests concentrates on stability of the system, while private interests of banks on their efficiency and incomes. Competition among the various groups, particularly intra industry rivalry within the banking system, contributes towards the optimal regulatory outcome (Kroszner). Rival banks have incentive to battle each other, and not only the government or consumers. Although banks will always have incentives to provide disinfomation, the ability to voice their position will benefit all, by educating the public regulator. Hence, deep and transparent financial market with a number of independent institutions should promote the optimal regulatory outcome.

7. The Regulatory Lessons for Poland from Global Tends

Currently, the Polish banking system consists of 72 banks. State ownership still influences banking industry, although it has dramatically declined (table 6).

Table 6: Relative Share of Particular Groups in the Total Number of Banks.

Number of banks 1993 1995 1998 VI 20011. Commercial

banks,Of which:

87 81 83 72

1.1 with majority public sector equity

29 27 13 7

1.2 with majority private-sector equity

58 54 70 65

1.21 with majority foreign equity

10 18 31 47

2. Cooperative banks 1 653 1 510 1 189 663

Source: NBP, GIBS (Sept. 2001) Summary Evaluation of the Financial Situation of Polish Banks.

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Bank profitability is still high: 15% RoE on average in 2000, although diminishing, due to adverse macroeconomic conditions. Majority of banks fulfil the risk-based capital requirements. The worrying symptom is high cost/income ratio and growing portfolio of non-performing loans (average of 16% of irregular loans in banks’ portfolios).

After 1989 banking reform, Polish regulatory regime entered initially liberal stage (1991-92). Then, banking crisis in 1992-93 changed the regulatory perspective. Justifiable fears connected with transitory phase resulted in 1992 in new legal amendments, aimed at stability and protection against failures. Consolidation of banks was encouraged and internal protection of the financial system implemented (mounting formal and informal requirements for getting banking license by foreign institutions). Since mid 1990s, however, the regulatory regime has been constantly evolving towards a better framework of conducting banking activities. New Banking Law of 1997 implemented the EU standards as to the limits on bank total exposure, bank investment in non-bank economic units or risk weighted capital adequacy ratio. The privatisation is almost completed and foreign banks are freely admitted.

After a decade of transformation, the banking market is largely market oriented and centred on efficiency and its current evolution is largely decided by market processes. Currently, Polish banks are undergoing a rapid process of consolidation or changes in the ownership base. As aggressive growth is no longer possible in a relatively stable macroeconomic environment, mergers and acquisitions and investment activities are the best strategy for expansion and growth. Regulatory institutions in Poland have been encouraging mergers and acquisitions among the top banks, as a safeguarding measure against the future more competitive environment. However, on the global market banks' face hostile competition from non-bank financial intermediaries, hence the growing concentration in banking is not dangerous from the welfare point of view. In less develop and liquid markets, like the Polish one, strong concentration and merging among the top banks may lead to redistribution of profits among banks with negative effect on customers’ satisfaction, economic welfare and banks' efficiency. For the future, the threat is that large universal banks will be the group with too much of political power. The concentration in Polish banking is not excessive, however the small, specialised banks are almost non-existent (4% of market share for co-operative banks).

Another frequently voiced concern is the dominant position of foreign banks (over 70% of financial assets and capital). However, foreign banks are less politically connected and less interested in regulatory capture and offer less potential for moral hazard behaviour. Negative effect may be the opposite: that they may exert too little pressure for the regulators for continuation of the financial reform.

Conflict of interests is a plaque for the international financial system. However, Polish banks are predominantly commercial in nature. Polish banks were even accused in the past of the „progress with a wrong model”. The wrong model, i.e. the separation of activities, spared us some scandals and conflict of interests, which may be illustrated by the bank BRE SA, the most aggressive and investment oriented in the Polish market. Its president

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have tended to be described as a role model for the industry. Recently, when the bank is active in hostile takover bids against its former clients, popular press describes him as a „wolf dressed up as bank president” (Rzeczpospolita 30.03.2002)

Conclusions

The future is ethical, says The Banker (April 2002). The recent banking scandals have attracted attention of public and private regulators to the behaviour of financial firms. The quality of a financial product is difficult to establish, hence the reputation is a key factor for a long run success of a financial firm, both investment and commercial, and the corporate culture in the long run must be based on values. However, we cannot forget that banks are profit maximising firms. R. Kroszner (2002) quotes a famous US bank robber, who when asked why he robbed banks, replied: „because that’s where the money is”. This may also be a public motivation for interest in banking industry. However, bank money is depositors’ money and bank main social responsibility is to conduct transactions in a safe and efficient manner. As Milton Friedman once observed, the biggest social responsibility of business is to increase its profits.

The regulatory regimes should ensure that the market, the depositors and the investors have efficient and stable institutions with transparent accounting and strategies, which are not too big to fail. The main regulatory objectives of : stability of the system, bank transparency and proper conduct, competition in the banking market, can be ensured by a mixture of public and private regulations, with growing importance of the latter. Respecting social norms and behaviours can to a large extend be imposed by a competitive market structure. However, public overregulation is as dangerous as lack of any regulatory interference in this respect.

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References

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