int’l financial system joint class ten financial intermediation and regulation

INT’L FINANCIAL SYSTEM JOINT CLASS TEN

FINANCIAL INTERMEDIATIONAND REGULATION

Prof. David K. Linnan UI-UGM-USC-UNDIP-USU Univ. of South Carolina Joint Videoconferenced ClassSchool of Law October 17, 2002

BANK VS. CAPITAL MARKETWhat defines a bank traditionally?

Takes deposits (short-term obligations) and makes loans (long-term assets), both on balance sheet

What defines a capital market traditionally?Purchase and sale of securities (equity or debt, stocks or bonds), traditionally through an underwriter (market risk, short-term on balance sheet) in primary market and through a broker (only settlement risk, effectively off balance sheet except for guaranty) in secondary market

BANK VS. CAPITAL MARKETRe general theory of financial

intermediation, both in theory reallocate capital based on supply & demand in a perfect world to achieve allocative efficiency

Traditional argument among financial economists whether (capital) market-based or bank-based financial systems better in terms of economic performance (understood in practice traditionally by proxy country as US/UK versus Germany/Japan financial system)

BANK VS. CAPITAL MARKETBank-Based Financial Intermediation View

Pro

Claim better for mobilizing (small into large) capital

Identifying good investments (project viability, individually examined w/ lending due diligence)

Direct monitoring of managers in long run relationship (contractual covenants too), but without potential negative effects in making info publicly available (where it might reach competitors)


Pro (cont’d)

Active risk management & reduced information assymetry given active due diligence possibility

Idea that the lower the general transparency level and the weaker the institutional side of a jurisdiction, the more suitable banks as powerful, well informed actors (e.g., developed vs. developing markets, or generically better where institutional structures weak)


Con

Powerful banks can protect established firms with close bank-firm ties from competition (denying financing to potential competitors)

Powerful banks with few regulatory restrictions on activites may collude with firm managers against other creditors

By nature banks are highly leveraged & contain asset (long-term) vs. liability (short-term) mismatch, so heavy monitoring exercise of bankers themselves to avoid bank insolvency (guarding the guardians, particularly given little transparency and idea that state may suffer if required to guaranty solvency generally)

BANK VS. CAPITAL MARKETCapital Market-Based Financial Intermediation View

Pro

Transparency and open price-determination enhance allocative efficiency

By slicing up securities into different interests, more efficient risk management (unbundling risks)

The incorporation of information dissemination into capital markets structures may have collateral value (political argument on monitoring “big capital,” but also ideas like comprtition policy)


Pro

Renders directly visible corporate governance issues in terms of control (choice of equity vs. debt too, vote & residual interest vs. fixed stream of payments), also allowing agency arguments to be addressed

Underlying claim that creating a public market itself reduces most problems with banking system approach


Con

Claims well-developed markets may reduce individual incentives to seek information

Claim that markets may permit too much liquidity in permitting investor easily to buy in or out (short-termism, plus tendency to sell out rather than really pursue coporate governance as control)

Idea that long-term relationships on borrower side in banking model more suitable, absent regulatory restraints, in better serving industrial growth in participating in insurance & securities activities (concept easier for a bank to function in capital market than it is for a securities company to function like a bank in its markets)

BANK VS. CAPITAL MARKETBANKS VS. CAPITAL MARKETS

Current view on the law & economics side of development economics is that the institutional structures (banking vs. capital markets) not nearly as determinative of economic growth as strength of underlying legal structures (so whether you have functioning bankruptcy law or contractual enforcement generally more important)

Problem of mistaking common law versus civil law question as “better” for economic growth, but really public law orientation

FINANCIAL INTERMEDIATIONAll of the preceding analysis institutionally oriented, meaning

regulation of banking as industry selling “banking products” vs. capital markets as industry selling “capital markets products”

More modern view says as both industries have deregulated, either need to regulate by function or by product (to extent post-deregulation in developed markets argue both overlap in selling each other’s services/products in different formats (whether universal bank, meaning the European bank-based systems incorporate capital markets operations like Deutsche Morgan Grenfell as well as selling insurance; or financial supermarket, meaning traditional US commercial banks like Citibank buy securities companies like Salomon Smith Barney and Travellers Insurance)

FINANCIAL INTERMEDIATIONFUNCTIONAL SERVICES FOR REG PRACTITIONER (BANKING

SUPERVISORS)

Access to payment system (electronic transfers vs. cash)

Access to liquidity on demand (demandable deposit versus standby credit)

Packaging and selling financial risk, meaning not only things like generic insurance but also securitization and reinsurance

Information/quality certification (attendant to repackaging function, meaning generic versus brand)

Conduit for government guarantees (whether access to lender of last resort, or deposit insurance)

FINANCIAL INTERMEDIATIONFUNCTIONAL SERVICES FOR FINANCIAL ECONOMISTS (FINANCIAL

MARKETS ORIENTED)

Methods of clearing & settling payments

Mechanisms for pooling of resources

Ways to transfer economic resources through time & across distances

Methods of managing risk

Price information to help coordinating decentralized decision-making in different economic sectors

Ways of dealing with incentive problems resulting from info asymmetries or agency problems

FINANCIAL INTERMEDIATIONBanking regulator’s view is that banks themselves

can no longer be supervised on a transactional basis for technology and deregulation reasons (note the prior example of universal bank versus financial supermarket, differing ultimately more in view of what goes on balance sheet)

Financial economist’s view is that product or functional regulation is the way to go because of innovation under deregulation (e.g., now derivative markets there since circa 1985) plus interchangeability of products means that investor strategies can be accomplished many ways

FINANCIAL INTERMEDIATIONFINANCIAL ECONOMIST’S VIEWS OF EQUIVALENT TRANSACTIONS

Taking a leveraged position in S & P 500 stocks (equity investment):

Buy each stock individually on margin (direct equity investment financed by broker)

Buy Vanguard S & P 500 index fund and borrow on your mastercardto finance it (pooled equity investment financed initially by bank until it securitizes its credit card receivables and sells them into capital markets)

Buy publicly traded futures contract on S & P 500 (publicly listed derivatives, traded through securities company)

Buy OTC forward contract on S & P 500 (privately traded derivatives, can be bought from bank or securities company)

You can borrow from a bank to buybuy a variable rate annuity contract from an insurance company with return linked to S & P 500 (insurance product bank- financed), etc.

FINANCIAL INTERMEDIATIONThe difference in functional versus institutional perspective is that

the options are equivalent but cast the transactions under different regulatory schemes

So if you want to regulate institutionally, pushed to either re-regulate (de-deregulate by limiting flexibility of financial intermediaries by category to sell only traditional products of their categories)

If you regulate functionally, you get go back to core functions lists and interrogate any financial intermediary on how the product fits the list and what attendant risks are that regulation is supposed to ameliorate as

1. Consumer protection2. Systemic risk3. Moral hazard if external guarantees (government

deposit insurance domestically, IMF bailout internationally)

FINANCIAL INTERMEDIATIONCOMPARE (1) REGULATORY PRACTIONER’S & (2) FINANCIAL ECONOMIST’S

FUNCTIONS FOR FINANCIAL INTERMEDIARIES

(1) Access to payment system (electronic transfers vs. cash)(2) Methods of clearing & settling payments ________________(1) Access to liquidity on demand (demandable deposit versus standby credit)(2) Ways to transfer economic resources through time & across distances

________________(1) Packaging and selling financial risk, meaning not only things like generic

insurance but also securitization and reinsurance(2) Methods of managing risk ________________(1) Information/quality certification (attendant to repackaging function, meaning

generic versus brand)(2) Mechanisms for pooling of resources

________________(1) Conduit for government guarantees (whether access to lender of last resort, or

deposit insurance)(2) Ways of dealing with incentive problems resulting from info asymmetries or

agency problems ____

FINANCIAL INTERMEDIARIESTHE ONLY DIFFERENCE?

(2) Price information to help coordinating decentralized decision-making in different economic sectors

SO IS THERE ANY DIFFERENCE BETWEEN THE BANKING REGULATOR’S VERSUS THE FINANCIAL ECONOMIST’S LIST, AND WHY/WHY NOT?

FINANCIAL INTERMEDIARIESTHE ONLY REAL DIFFERENCE SEEMS TO BE ECONOMIST’S IMPLICIT FOCUS

ON DERIVATIVES AS NEW INSTRUMENTS NOT FALLING INTO TRADITIONAL BANKING OR CAPITAL MARKETS PRODUCT CATEGORIES, AND THEY ARE IN BOTH MARKETS, E.G., EQUIVALENT TRANSACTIONS PROBABLY DERIVATIVE BASED:

Buy Vanguard S & P 500 index fund and borrow on your mastercardto finance it (pooled equity investment financed initially by bank until it securitizes its credit card receivables and sells them into capital markets)

Buy publicly traded futures contract on S & P 500 (publicly listed derivatives, traded through securities company)

Buy OTC forward contract on S & P 500 (privately traded derivatives, can be bought from bank or securities company)

You can borrow from a bank to buy a variable rate annuity contract from an insurance company with return linked to S & P 500 (insurance product bank- financed)

FINANCIAL INTERMEDIATIONDERIVATIVES ARE REALLY JUST ABOUT RISK MANAGEMENT, E.G.,

SLICING UP RISKS SUCH AS

Insurance risks (weather bonds, commodities contracts, but also for terrorism risks could go to Lloyds for war risk insurance meaning hostile action like against the French ship a week ago, or just buy a put for Jakarta stocks at BES, or rupiah forward contract from an Indonesian or Singapore bank)

Foreign exchange risks (all foreign currency bonds, for example those sold by Indonesian companies in Singapore pre-1997, or currency swaps from a bank, etc.)

Banks now sell credit derivatives (e.g., if a big borrower were to default on a loan the credit derivative as a kind of guaranty provides for 3-p payments in place of borrower)

THE ISSUE IS THAT DERIVATIVES TEND TO BE LEVERAGED BETS AND DIFFICULT TO VALUE SINCE TIED TO CONTINGENT, EXTERNAL EVENT

BASEL STANDARDSLOOK TO BIS & BASEL CAPITAL ACCORDS FOR WISDOM PAST 10 YEARS

AND PROSPECTIVELY

Since 1992 risk-based 8% Basel capital requirements, with real issues in haircut weighting (older style liquidity guarantee, unforeseen incentives and valuation/risk estimation problems)

Current proposal (for 2006 implementation theoretically), three pillars are

1. Minimum capital requirements (still 8% in theory, but now modelling credit, operational & market risk w/ banks able to determine internally)

2. Supervisory review, of internal risk assessment and controls (note not trad. transaction based

super.)

3. Market discipline (meaning do detailed risk disclosures and the markets will tell you the bank’s market capitalization)

WHERE IS THE DISTINCTIVE BANKING REGULATION APPROACH NOW?

US BANKING REG HISTORYHOW WE GOT HERE

National Bank Act of 1864Pre-existing state banks (free banking

tradition since 1838, meaning not a specific charter as business license), so created dual banking system and defined “business of banking” as to this day deposit-taking & extension of credit

US BANKING REG HISTORYHOW WE GOT HERE (Cont’d)

Federal Reserve Act of 1913Created Federal Reserve as central

bank plus gave prominent role in banking supervision


Edge Act of 1919International banking authorization for

banks to create special purpose subs (so Citi is not new phenomenon)


McFadden Act of 1927Established dominance of state

banking laws to determine interstate banking structures, essentially prohibiting interstate branching in theory to preserve community banking


Banking Acts of 1933 & 1935As response to 1930s banking crisis, 1. separate commercial from investment banking

(so commercial banks could not be universal banks in European model, investment banking being core capital markets activity),

2. established interest ceilings on deposits, 3. established FDIC as insuror with regulatory

powers,4. restricted bank activities particularly interlocking

directorates and insider lending,5. generally broadened supervisory powers


Federal Home Loan Bank Act of 1932 and Federal Credit Union Act of 1934Established parallel institutions with special housing & mutual markets covered also by insurance, with own parallel regulatory structure


Bank Holding Company Act of 1956 & 1970 amendments

Federal regulation for bank holding companies under Federal Reserve, in effect upholding longstanding rule that financial & industrial sector ownership separated


Savings & Loan Holding Company Act of 1967

Parallel S & L regulation like BHCA, but under FHLBB

US BANKING REG HISTORYHOW WE GOT HERE (Cont’d)Depository Institutions Deregulation & Monetary

Control Act of 1980

1. First big deregulatory financial sector statute,2. phasing out deposit interest rate ceilings,3. Expansion of permissible S & L activtties4. Authorizing nationwide NOW accounts

(negotiable order of withdrawal, a special check-like instrument)

Background of S & Ls suffering asset & liability mismatch & opening up competition in sector more generally


Garn-St. Germain Depository Institutions Act of 1982

1. Authorised money market deposit accounts (basically, competition from mutual fund industry selling commercial paper destroyed interest rate ceiling & this duplicated competition’s product),

2. Strengthening S & L industry again


Competitive Equality Banking Act of 1987

Targeting so-called non-bank banks as unregulated lenders, given that businesses were trying either to not take deposits (usually), or not make loans going all the way back to 1864 banking activity definition, but grandfathering institutions like consumer finance & industrial lenders (Household Finance, GE Credit, etc.)


Financial Institutions Reform, Recovery and Enforcement Act of 1989

1. Replaced FHLBB with OTS in Treasury as supervisory authority for S & Ls,2. Created Resolution Trust Corporation (RTC) for managing failed thrifts & selling assets,3. Re-regulated much of S & L asset side (investments, meaning lending mostly), cutting back on non-housing loan activities plus commercial real estate lending

Functionally, a decent burial for the S & L industry debacle of 1980s

US BANKING REG HISTORYHOW WE GOT HERE (Cont’d)Riegle-Neal Interstate Banking and

Branching Efficiency Act of 1994

Basically undid the McFadden Act in enabling interstate branching and so nationwide branching (in part in response to pressure on S & L side, meaning banks threatened to convert to thrifts, since they did not have the same constraints)


Gramm-Leach-Bliley Act of 1999

Basically undid formal prohibition in Glass-Steagall Act of commercial banks doing investment banking activity and 1956 BHCA of insurance activity if done through a bank holding company structure, with the result that we now have Citigroup, meaning Citibank-SalomonSmithBarney-Travellers as “financial supermarket”-- however, there had been regulatory loosening since early 1980s under regulatory interpretation of what was permitted “banking business,” etc.


How do you regulate Citigroup realistically as a worldwide financial conglomerate? Instead, drifting under Basel Accord towards what begins to look a little like capital markets SRO self-regulation….

We have gotten here because

1. technology changing the nature of financial services,

2. the sheer size of institutions like Citi (growing concentration),

3. blurring of lines re financial products such as uninsured money market funds as SEC-regulated investment companies investing in commercial paper versus traditional insured bank deposits, and

4. financial engineering practices like securitization and the secondary mortgage market with GNMA guarantee under which for housing we really no longer need S & Ls as real dedicated lenders.

OTHER MODELS?HOW WE GOT HERE (Cont’d)

What are the appropriate regulatory models outside US (consolidated financial sector regulators looking at UK first)?

US probably stuck with Fed as central bank vs. Fed Banking Regulators (OCC, FDIC, Fed) vs. State Banking Regulators vs. SEC vs. State Blue Sky vs. CFTC vs. Credit Unions, etc. and federal/state regulatory split on insurance generally as matter of political economy,

1. Unless and until we have a high-enough profile financial institution debacle to trigger another round of regulatory reform.

2. So, was Enron that debacle in waiting or is it really a regulatory success?

3. In what regulated business, if any, was Enron actually engaged?

int’l financial system joint class ten financial intermediation and regulation

Documents

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capital marketcapital

capital marketwhat

financial economists

financial systems

monitoring big capital

capital markets structures

underwriter market risk