Regulation of global banking principles and policies taylor

These standards bridge the gulf between domain the geographical area over which financial institutions and markets operate and jurisdiction the machinery of legislation and regulation t

Global Bank Regulation

For Pete, Steve, Thor and John (H.M.S.)

Global Bank Regulation Principles and Policies

Heidi Mandanis Schooner Michael W Taylor

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Schooner, Heidi M.

Global bank regulation : principles and policies / Heidi M Schooner, Michael Taylor.

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Includes bibliographical references and index.

ISBN 978-0-12-641003-7 (alk paper)

1 Bank management 2 Financial institutions 3 Globalization I Taylor, Michael (Michael W.), 1962- II Title.

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Introduction: The Global Financial System and

5 Sources of Financial Regulation 73

Changes to Structural Regulation of the Combination of Banking

15 Institutional Structures of Regulation 259

The Global Financial

System and the Problems

Although the government agencies responsible for regulating global markets and institutions remain rooted in national legal systems, they have increasingly sought convergence of their rules and regulations European Union countries have agreed

on common minimum standards and oblige their national regulators (through national treaty) with implementation In the rest of the world, convergence on

inter-minimum standards centers on soft law, with informal international groupings

of regulators seeking compliance with their standards through force of example and other forms of moral suasion The most important such group is the Basel Committee on Banking Supervision (Basel Committee or BCBS), a body that brings together central banks and regulatory agencies from North and South America, Europe, and Asia

International standards set by bodies like the BCBS and the European Union

are the main focus of this book These standards bridge the gulf between domain

(the geographical area over which financial institutions and markets operate) and

jurisdiction (the machinery of legislation and regulation that ensures the orderly operation of markets).1 The fact that the regulatory system remains fragmented along

1 These terms were first used to describe the disconnect between global markets and the arrangements for

their governance by the economist Richard N Cooper in his 1968 book The Economics of Interdependence.

national lines while financial institutions operate far beyond the borders of their home countries remains a significant and persistent challenge to regulatory policy The Global Financial Crisis that began in the summer of 2007 made this issue one

of more than mere theoretical relevance

In this introduction, we begin with a broad overview of the aims and purposes

of banking regulation and then discuss how the development of a global financial system complicates the task of regulating firms with border-crossing operations The fundamental problem is how to ensure adequate supervision of a firm that operates

in many different countries, across all time zones We follow with a brief discussion

of the policy networks, including bodies like the BCBS, which assist regulators with

this global challenge The output of these networks, in the form of international standards and agreements, is the main focus of this book Finally, we end with a brief overview of the book’s structure and how it might be used in teaching courses

on the regulation of international banking

The Rationale for Regulation

Bank regulation is concerned primarily with ensuring that banks are financially

sound and well managed In the United States, this concept is referred to as safety

and soundness regulation and in most of the rest of the world as prudential

regula-tion Although banks are subject to many other forms of regulation, including sumer and investor protection requirements, these regulations receive only our passing attention The focus of this book is on prudential regulation, and we therefore begin with an explanation of why governments subject banks to prudential regulation

con-Governments intervene in the operation of a market economy, whether through taxation or through regulation, for two primary reasons: either to ensure that markets work efficiently or to alter market outcomes to achieve social objectives With only a few exceptions,2 tax policy is most often used to achieve social objectives For example, a tax on the wealthy can be used to redistribute wealth to those less fortunate through welfare programs On the other hand, the general objective of regulation is market efficiency Since economists usually refer to market inefficien-

cies as market failures, regulation is often described as an attempt to correct a market

power If one or a few firms have the power to restrict competition, they are likely

to raise prices, restrict supply, offer poorer service, and restrict innovation The distortion of the market through the exercise of monopoly power supports anti-monopoly and anti-cartel legislation as far back as the United States’ Sherman Antitrust Act (1890) and as recent as the United Kingdom’s Competition Act 1998

The second way in which markets can fail is through the existence of extern alities

or what are sometimes referred to as spillover costs.3 These arise when the economic activities of some participants in a market indirectly affect, positively or negatively, the well-being of others Positive externalities arise in a wide variety of contexts For example, a popular restaurant that brings customers to nearby businesses is not compensated for the value of the positive externality it generates Regulation, however, is typically employed to correct negative, rather than positive, externali-ties A negative externality exists when the price of a good does not reflect the true cost to society of producing that good In the classic example, if a steam train emits sparks that occasionally burn the crops of nearby farmers, the cost of the destroyed crops is a spillover cost (externality) imposed on the farmers by those who use the train To account for this externality, either the users of the train could be taxed to compensate the farmers or the emission of sparks from a railway locomotive could

be regulated, for example, by setting standards for the construction of locomotive chimneys

The third justification for regulation arises from the existence of information imbalances (“asymmetries”).4 In a well-functioning market, buyers and sellers possess all the information needed to evaluate competing products or services Buyers and sellers must be able to identify the alternatives available and understand the characteristics of the goods or services offered Yet, information is a commodity like any other, and markets for information can fail like any other For example, one

of the parties to a transaction may deliberately seek to mislead the other, by ing false information or failing to disclose key facts Failures in the market for information justify regulation of various types—for example, food labeling or dis-closures in securities offerings

convey-The Regulation of Financial Institutions and MarketsRegulation over the past three decades has rested on the notion that markets are essentially rational and highly efficient at allocating resources and that markets are generally self-policing and self-correcting Given these assumptions, regulatory

3 See the appendix for a more extensive discussion of externalities.

4 See the appendix for further discussion of information asymmetry.

intervention could be justified only to the extent necessary to correct the tively rare instances in which markets may fail In the context of banking, these market failures take two main forms: information asymmetry and systemic risk (a negative externality) Most of the regulations examined in this book represent attempts to correct these two types of market failure.

compara-InformatIon asymmetrIes

In the first place, the justification for the regulation of financial institutions and markets arises from the existence of information asymmetries Information asym-metries are common in many product markets Many products are complex, are difficult to understand and compare, or involve a substantial investment (e.g., the purchase of a car) What makes financial products different is not the existence of these characteristics, but their nature and intensity The essence of a financial con-tract is a promise that money placed in an investment today will be paid back in the future This contract exists between a depositor and a bank; a policyholder and insurance company; an investor and a mutual fund

With the bank deposit, the bank promises to return the depositor’s money, with the contractual interest, anytime the depositor demands it (as with a checking account) or at some future date (as with a certificate of deposit) The bank, however,

is in a much better position than its depositors to judge the bank’s ability or intention

to make good its promise In the most extreme case, a bank might take deposits that

it has no intention of honoring (this happened with the Bank of Credit and Commerce International, a case we study in Chapter 12) Similarly, the depositors’ funds might

be used for the benefit of the owners of the firm or to offer higher returns to other depositors (as happens, for example, with Ponzi schemes5) However, even an honest bank may, through poor management or bad judgment, fail to honor its promises, causing depositor losses

While a depositor should assess the quality of the product offered (i.e., a promise

by the bank to repay the deposit, plus an agreed rate of interest), the quality of a bank deposit depends on the financial soundness of the depository bank The asym-metric information between the bank and its depositor leaves the depositor unable

to judge the bank’s financial condition This not only increases risk to the depositor, but also makes it difficult for a solvent, well-managed bank to convey credibly the reliability of its promise The result is Akerlof’s market for lemons, discussed in the appendix

5 A Ponzi scheme is a fraudulent investment in which investment returns are funded by new investors rather than actual profits The technique derives its name from Charles Ponzi, who was notorious for employing such a scheme in the early 1920s.

Depositors and other bank creditors suffer from an information asymmetry that stems from the nature of a bank’s assets Loans that banks make to individuals and business borrowers comprise the traditional bank asset Yet, it is very difficult for those outside the bank to evaluate these loan assets The reason is that banks have access to information about their borrowers that is not available to others, including the bank’s depositors and potential depositors Thus, a bank’s depositors and other creditors have difficulty assessing a bank’s solvency because they cannot indepen-dently verify the value of a bank’s assets When depositors and other creditors have difficulty verifying the bank’s solvency, they cannot be assured that the bank will live up to its promise to pay.

Even if information is available, most bank depositors lack the technical expertise

to evaluate the information given, just as airline passengers are unable to assess a plane’s airworthiness even if they are given all the key technical specifications regarding the aircraft Moreover, even with the requisite technical expertise, the value of a bank’s assets can be very difficult for a third party (i.e., someone who is neither the bank nor its borrower) to assess In response to this problem, some economists have favored market value accounting for banks, which would force banks to value their assets at their current market price But the majority of bank assets (i.e., loans) do not have a ready market, and thus assigning them a market price is highly speculative

The existence of asymmetric information also gives rise to the problem of adverse selection Adverse selection is an asymmetric information problem that occurs when the parties who are most likely to produce an undesirable (adverse) outcome are the ones most likely to be selected Adverse selection affects the ability of the market mechanism to match up feasible trades, i.e., trades that both buyer and seller would

be willing to undertake if doubts about quality were removed In some cases, adverse selection can prevent the emergence of a market altogether

In an unregulated banking system, depositors are likely to confront an adverse selection problem The value of a bank deposit depends heavily on the honesty, probity, and competence of the bank itself, and these are qualities that are difficult for most customers to judge If bank depositors are doubtful about the honesty of bankers, they will demand high interest rates to compensate themselves for the risk that their deposit will never be repaid But honest bankers will find it difficult to generate the kinds of returns that would enable them to pay depositors such high interest rates Therefore, the only people who will promise depositors high rates of return are those who make their promises fraudulently Either depositors will rec-ognize the unrealistic promises of gain and take their business elsewhere, or they will be attracted by the promises of high returns and place their money in the hands

of fraudsters By the time the bank’s promises are exposed as fraudulent, most depositors will have already lost their savings

To minimize the risks to depositors, many governments around the world provide—either implicitly or explicitly—some form of guarantee or insurance in the

event that a financial intermediary fails to meet its obligations Thus, deposits with

a bank are guaranteed by deposit insurance programs (outside the United States, such programs are often referred to as deposit insurance schemes) up to a certain maximum Similar government-sponsored programs protect insurance policyholders from the risk of failure of their insurance company

When governments offer such guaranties, they do so with strings attached ernments regulate the firms whose solvency is being insured to limit the potential claims on the various compensation schemes This forms much of the justification for regulation of insurance companies, and is also an important rationale for the regulation of banks For example, government sponsored deposit insurance justifies the requirement that banks be licensed, that their management be fit and proper, and that the banks are run in accordance with regulatory mandated minimum levels of capital and liquid assets

Gov-systemIc rIsk

By their nature, financial contracts involve promises to make future payments at specified times, in specified amounts, and in specified circumstances The more sophisticated the economy, the greater its dependence on financial contracts and the greater its vulnerability to the failure of the financial system to fulfill its contracts The indispensable role of finance in a modern economic system and the potential for financial failure to lead to systemic instability introduce an overarching external-ity that can impose significant costs both in terms of the level of economic output and government revenues

Systemic instability is defined in a variety of ways, but in general arises when financial distress in one financial institution is communicated to other institutions Such contagious distress may occur when problems in one institution trigger a crisis

of customer confidence in other institutions Alternatively, the failure of one tion to settle its obligations may cause the failure of other, fundamentally sound, institutions Traditionally, banks (i.e., deposit-taking institutions) were considered uniquely susceptible to this type of contagion Banks’ susceptibility to financial crisis stems from the precarious nature of the financial service they provide, which transforms illiquid assets (loans) into liquid liabilities (deposits) A bank’s commit-ments can be met in normal times because customers’ demand for access to their deposits is reasonably predictable and banks hold liquid assets to meet this demand However, when a sufficiently large number of depositors demand their funds simul-taneously, the bank’s commitments cannot be met without some form of outside assistance Since all banks suffer from the same potential weakness, and depositors have difficulty distinguishing between a sound bank and an unsound one, a crisis of confidence in one bank can quickly spread to others Further, a mere concern about

institu-a binstitu-ank’s insolvency, whether or not well founded, minstitu-ay be sufficient to institu-actuinstitu-ally cinstitu-ause insolvency if the bank’s assets have to be liquidated at reduced, firesale prices to meet the demands of withdrawing depositors.

A further source of contagion among banks is that they participate in the ments system, through which obligations are settled between financial intermediar-ies The failure of one participant in that system to meet its obligations can impede the ability of other participants to meet their own obligations Disruption to the pay-ments system can in turn precipitate a wider economic crisis Arguably, the core of the payments system poses the greatest systemic risk

pay-Systemic risk is costly both in terms of lost economic output and the public funds spent in bailing out banks According to a survey conducted by a team of the Inter-national Monetary Fund (IMF), between 1980 and 1996, 133 out of 181 IMF members suffered either “significant problems” or a “crisis” in their banking sectors During this period there were 41 identified crises in 36 countries (Lindgren et al.,

1996, p 20) The effect on the real economies and on the fiscal systems of those countries experiencing banking crises was generally severe In the United States, the cost of resolving the savings and loan crisis of the late 1980s was roughly 5.1% of GDP According to the IMF, the costs of restructuring banking systems as the result

of banking crises have varied from 4.5% of GDP in Norway and Sweden in 1991

to 19.6% of GDP in Chile in 1985 Given the substantial costs associated with a systemic crisis, regulation throughout much of the world for the last 100 years has focused on the prevention of such crises

The Case for International Regulation

Concerns over systemic risk dominate international bank regulation The BCBS’s

statement of best practices for bank regulation, the Core Principles for Effective

Banking Supervision (“Core Principles”), explains its purpose in terms of the tial for “[w]eaknesses in the banking system of a country … [to] threaten financial stability both within that country and internationally” (Basel Committee on Banking Supervision, 2006, p 2) In other words, the primary concern of international bank regulation is avoiding spillover of banking problems from one country to another.Spillovers from one national banking system to another can occur both directly and indirectly Direct spillovers occur when a bank headquartered in one jurisdiction has significant operations in other jurisdictions If this bank’s solvency suffers, depositors in all the jurisdictions in which it operates can be adversely affected Therefore, bank regulators require rules for deciding which of them should take responsibility for regulating banks with significant border-crossing operations

poten-to ensure that these banks are always subject poten-to effective supervision Effective international regulation also requires that all countries apply broadly equivalent

prudential requirements so that a bank operating from one jurisdiction is not cantly less regulated than banks operating from other jurisdictions A bank that bases its operations in a jurisdiction offering light regulation can pose significant risk

signifi-in the other jurisdictions through the bank’s cross-border operations Moreover, the lightly regulated bank puts more rigorously regulated banks at a competitive disadvantage.6

Another form of direct spillover derives from the international payments system and is illustrated most clearly by the closure of Bankhaus Herstatt in 1974 (see Chapter 3) Payment systems risks are increasingly internationalized, as are other linkages between banks, especially in the interbank market One of the root causes

of the 1997–1998 Asian crisis was short-term lending by developed-world mercial banks to poorly supervised Asian banks The withdrawal of this funding was the cause of severe liquidity problems in several Asian banking systems In today’s market-based financial system, banks are also more likely to be the purchasers of assets originated in other jurisdictions In the Global Financial Crisis (2008–2009), European banks’ initial heavy losses were caused by their exposure to securities backed by subprime mortgages in the United States These losses in turn constricted European banks’ ability to make new loans, causing an economic recession, and leading to a new round of loan losses as their own borrowers defaulted

com-Spillovers may occur indirectly through a variety of channels In a global media environment, panic in one country can soon spread to another One of the most

significant indirect channels of financial crises is what is known as contagion In

today’s globalized financial system, problems that develop in one country can be rapidly transmitted to others if international investors perceive that investing in two different countries involves broadly similar risks Examples are numerous In 2009, the banking systems of all the countries of Central and Eastern Europe suffered from capital flight and deposit withdrawals, even though only a few of the countries had significant problems in their banking systems Ten years earlier, the countries

of East and Southeast Asia suffered from a similar phenomenon Even earlier in economic history, in 1931, Central Europe also suffered from contagion effects These contagion effects can become self-fulfilling prophecies, as the very act of withdrawing deposits from one country’s banking system can cause its banks to collapse

The benefits of high standards of bank regulation are felt not only by the countries that make such standards a priority Financial stability is what economists call a

global public good in which all countries benefit from financial stability, whether

or not they contribute to it The recognition of spillover effects is an important

6 Of course, an alternative approach would be to exclude banks from lightly regulated jurisdictions from operating in those jurisdictions with more rigorous regulation This approach, however, is generally regarded as excessively protectionist.

motivation behind the BCBS’s push for universal adoption of the Core Principles

These interlinkages provide strong incentives for bank regulators to ensure that all countries responsible for licensing and supervising banks adhere to a set of common minimum standards, such as the standards discussed in this book

competItIve equalIty

A subsidiary issue that arises in the international context is the question of petitive equality.7 If institutions regulated in different jurisdictions are subject to different prudential requirements, then some of them may enjoy a competitive advantage For example, if one regulator requires its banks to hold $8 of capital for every $100 in loans that it makes, and another regulator only requires its banks to hold $4 of capital for the same volume of loans, it is clear that banks from the second country will be at an advantage Since they are required to hold less capital against their loans, their costs will be lower and they will be able

com-to make loans at a lower price (interest rate) Thus, banks with a high capital requirement will be disadvantaged in competing against banks with a lower capital requirement

Given the very real possibility that a nation’s regulations or policies could put its institutions at a competitive disadvantage globally, policy-makers may respond by changing their regulations or policies This willingness to change national regula-tions in response to the regulations of other countries can be viewed as a competitive process In the case of bank regulations, regulators from different nations compete with one another as providers of regulatory services As explained by Kane (1987,

p 119), “financial analysis has focused traditionally on competition for customers

by those who produce and distribute financial services But running parallel to this competition between private financial institutions is a less-visible layer of competi-tion for rights to produce and deliver regulatory services to [f]inancial institutions.” While financial institutions compete on the basis of the price of their services, finan-

cial regulators compete on the basis of a net regulatory burden (NRB) The NRB is

composed of both costs and benefits Imposing capital requirements on banks’ ity is an example of a regulatory cost A central bank’s support of the payment system is an example of a regulatory benefit The combination of the aggregate costs and benefits produces an NRB for each country Thus, a country with an NRB that

activ-7 The notion of competitive equality is, however, important at the national level in the United States The United States maintains an internationally unique dual banking system in which both states and the federal government authorize and regulate banks This means that U.S lawmakers are often faced with claims that either the state or federal system provides a competitive advantage or disadvantage over the other.

is higher than other countries’ will, in theory, place its constituent banks at a petitive disadvantage.

com-The key policy question regarding differences in countries’ NRB is whether such differences lead to a competitive process that causes countries to change the nature

of their regulations to lower the NRB If this is true, then one might observe an overall convergence of NRBs toward some point of equilibrium (which would be the natural course of events in a typical competitive market) Policy convergence can be observed following the New York Stock Exchange’s decision to abandon

fixed commissions on May 1, 1975 (known as May Day on Wall Street) The

NYSE’s move prompted a series of deregulatory measures in London, Tokyo, Toronto, and Paris This provides a clear example of a case in which competition in rules promotes a process in which regulations of different countries converge, i.e., countries begin to adopt the same or similar rules

The problem with this analysis is that there can be both a good and a bad librium Many regulators worry that competition among regulators results in a race

equi-to the botequi-tom in which regulaequi-tory standards fall equi-to the lowest common denominaequi-tor They point to the Delaware phenomenon in U.S corporate law as a prime example.8

If some jurisdictions in effect undercut their competitors by offering a lower net regulatory burden, then they will force other jurisdictions to follow suit Otherwise, business will flow out of more regulated countries to the most lightly regulated countries While this competitive process can prove beneficial in that it forces regula-tors to do away with unnecessary or ill-thought-out regulations, it can also have costly implications In a world of open international markets, lightly regulated banks could transmit their deficiencies around the world, causing serious spillover effects and imposing serious costs on jurisdictions that maintain higher regulatory stan-dards Therefore, competition among regulators cannot be allowed to reach the point where minimum standards fall below levels necessary to preserve international financial stability

The emergence of international standard-setting bodies, such as the BCBS, responded to this problem In effect, these bodies set the minimum standards that their members agree to meet to prevent a race to the bottom Member countries can apply higher standards than those that have been internationally agreed, but none of

8 In the United States, corporations can be chartered by any of the 50 states (banks can also choose to be chartered by the federal government) Thus, states compete for corporate charters to gain the fees and other associated economic benefits Delaware has been the driving force in this competition among the states Critics complain that Delaware has adopted exceedingly management-friendly laws to attract corporate managers while shareholder rights have suffered As a result, the majority of U.S corporations are chartered in Delaware While the Delaware phenomenon has its critics, some praise the competitive process as one that has produced a state with a high level of expertise in corporate law The Delaware corporate statutes and the state’s judicial opinions are read and studied around the world.

them should apply a lower standard Such cooperation produced some of the most significant convergence in regulation, e.g., the Basel Capital Accord, over the past several decades Schooner and Taylor (1999, p 598) describe the work of interna-tional standard setters as “ ‘negotiated convergence’ because the outcome is derived from extensive negotiation between different national authorities and involves the usual compromises and trade-offs inherent in bargaining.”

Who Sets the Standards?

Since the mid-1970s, central bankers and bank regulators have recognized the risks presented by an internationally integrated global financial system and the need for international coordination and cooperation The BCBS has provided the most high-profile and internationally respected response to these problems The BCBS, which

we discuss further in Chapter 5, is an example of what international relations

theo-rists call a policy network The policy network concept originated in what Robert

Keohane and Joseph Nye (2000, p 344) term “transgovernmental” activity, which they defined as “sets of direct interactions among sub-units of different governments that are not controlled or closely guided by the policies of the cabinet or chief execu-tives of those governments.” In recent years, as Anne-Marie Slaughter has noted, policy networks have become much denser as the scale, scope, and types of trans-governmental ties have responded to the challenges of globalization These net-works, she argues, offer “a flexible and relatively fast way to conduct the business

of global governance, coordinating and even harmonizing national government action while initiating and monitoring different solutions to global problems” (Slaughter, 2004, p 11)

A series of horizontal networks have emerged among national government cials in their respective policy arenas, ranging from central banking through antitrust regulation and environmental protection to law enforcement and human rights pro-tection These networks operate both between high-level officials directly responsive

offi-to the national political process, i.e., ministerial level, as well as lower-level national regulators They discharge several different functions:

n Information networks “bring together regulators, judges, or legislators to exchange information and to collect and distill best practices This information exchange can also take place through technical assistance and training programs provided by one country’s officials to another” (Slaughter, 2004, p 19)

n Enforcement networks “typically spring up due to the inability of government officials in one country to enforce that country’s law, either by means of a regu-latory agency or through a court” (Slaughter, 2004, p 19)

n Harmonization networks “bring regulators together to ensure that their rules

in a particular substantive area conform to a common regulatory standard” (Slaughter, 2004, p 20)

In this book we will focus primarily on the harmonization networks that central bankers and bank regulators have established to ensure that the global, integrated financial system operates according to a common set of rules The BCBS is the most important of these policy networks Its recommendations and policy papers are now closely followed by many regulators and regulatory agencies around the world, including many that are not represented on the committee itself The European Union (EU) also plays an important role in setting international bank regulatory standards, sometimes in advance of the BCBS and sometimes following its lead As Slaughter has argued, the EU can also be thought of as a policy network, although one of a very distinctive type However, these institutions are only part of a complex series

of policy networks that grapple with the mismatch between domain and jurisdiction

in the new world of international finance

How to Use This Book

The first section of this book, comprising four chapters, explores the main tions for the prudential regulation of banks and explains why a financial safety net

justifica-is needed Students who are familiar with such concepts as fractional reserve banking, externalities, and the role of the lender of last resort, perhaps because they have completed an undergraduate course on money and banking, may skip certain sec-tions of these chapters, although they may also find that the relevant policy issues are discussed in greater depth than they may have previously encountered Students without a background in economics are encouraged to make use of the material in these chapters as well as the appendix, which explains some of the relevant economic theory

Chapter 1 is concerned with the changing nature of banks We look at ways in

which various legal regimes around the world have attempted to define bank or

banking and then turn to consider what it is about banks that has made them subject

to a level of regulation that exceeds that applied to most other types of economic activity Central to the traditional definition of banking is the concept of deposit taking, and the nature of banking involves both the extension of long-term credit while at the same time promising depositors that their funds will be available on demand We also describe the way in which the nature of banking has been trans-formed in the past three decades, coming to rely on funding sources other than traditional deposits, such as loans raised from other banks or commercial paper issued in capital markets

Chapter 2 examines the standard economic case for bank regulation based on the fragility of banks’ promises to repay depositors on demand A bank can meet its promise to depositors only if all depositors do not ask it to honor its promise at the same time The inherent fragility of this situation creates an incentive for depositors

to engage in runs, and this forms the main traditional justification for the regulation

of banks

Chapter 3 examines another feature of banks They form an interconnected system of mutual financial obligations The interconnected system gives rise to the concern that the failure of one bank to meet its obligations will trigger a domino-like collapse of other banks Although this particular scenario is now thought to be comparatively remote, the shift toward a banking system that is dependent on inter-bank and financial markets for the main source of its funds creates the risk that banks could be brought down by asset price spirals caused by banks attempting to liquidate their assets at the same time This factor forms a major part of the explanation of the severity of the Global Financial Crisis of 2007–2009

Chapter 4 considers the financial safety net, the institutions that society has created to protect against the risks described in Chapters 2 and 3 Central to the financial safety net is the role played by the central bank in its capacity of lender of last resort In addition, deposit insurance also plays an important role in minimizing the incentives for depositors to engage in bank runs Finally, Treasuries or Ministries

of Finance have a role to play as a backstop to the entire system However, the existence of a safety net encourages moral hazard, giving banks an incentive to take

on higher risks in the expectation of being bailed out Moral hazard serves as the main justification for regulation in that it provides a counterbalance to the distorted incentives created by the financial safety net

Chapter 5 represents a change of focus and provides a link between the first four chapters and the rest of the book In it we describe in greater detail the main policy networks and standard setting bodies that have been responsible for devel-oping international standards for bank regulation We also look at the role played

by the European Union in setting bank prudential standards for its member countries

Chapter 6 is the first chapter in which we turn to the specific regulatory ments that form the substance of most of the other chapters of this book In this chapter we examine both the relevant international standards on bank licensing requirements and also how several leading jurisdictions have applied these standards

require-in practice We also look at issues of corporate governance as applied require-in particular

to banks

Chapter 7 examines who owns banks We consider how countries have responded

to the questions of whether a commercial (i.e., nonfinancial) firm should be allowed

to own or affiliate with a bank and a bank’s affiliation with or ownership by other financial institutions such as insurance companies or securities firms

Chapters 8, 9, and 10 examine the regulation of bank capital, one of the most important areas of regulation in international banking The regulation of capital is a highly technical field and is a popular subject in finance literature This book attempts to describe capital regulation for the nonexpert and, therefore, focuses on overarching policy principles rather than attempting to convey understanding of complex finance principles Chapter 8 reviews the nature of bank capital and consid-ers why it is necessary for bank regulators to set minimum capital requirements for banks Chapter 8 introduces the Basel I capital standards that formed the basis for capital regulation around the globe Chapter 9 considers the ways in which Basel II attempts to deal with limitations in the way that Basel I treated credit risk Chapter

10 examines Basel II’s treatment of other risks, in particular market and operational risk

While capital regulation can indirectly limit a bank’s risk taking, in Chapter 11 we consider how regulations do so directly In this chapter we consider regulations that address credit concentration risk and liquidity risk This chapter provides a fairly detailed examination of large exposure rules in the United States and the United Kingdom for those that wish to delve deeper into special legal rules

Chapter 12 examines the practice of consolidated supervision Consolidated supervision addresses the supervisory challenges that relate to (1) banks operating cross-border and (2) banks operating within larger conglomerate groups that engage

in nonbanking activities such as insurance or investment banking

Chapter 13 looks at international efforts to combat money laundering and terrorist financing, how those efforts impact bank operations, and why these issues are impor-tant to bank supervisors (as opposed to criminal prosecutors)

The Global Financial Crisis vividly demonstrates that banks continue to fail despite extensive regulation and monitoring In Chapter 14 we consider the mecha-nisms for resolving failed institutions and how such mechanisms are used to resolve financial crises We also consider the particular challenges posed by cross-border insolvencies

Chapter 15 visits the international debate over the institutional structure of cial institution regulation We examine the models adopted around the world and current trends in structural reform

finan-Chapter 16 concludes the book with a discussion of the Global Financial Crisis The chapter begins with an examination of the causes of the crisis and considers the extent to which regulation was to blame Next, the chapter outlines current proposals for reform While it is too early to know which, if any, of these proposals will be implemented, we believe that reform will engage the policy networks emphasized

in this book and may form the next generation of international standards of financial institution regulation

Keohane, R.O., Nye, J.S., 2000 Power and Interdependence, third ed Pearson Higher tion, Boston, Mass.

Educa-Lindgren, C.J., Garcia, G., Saal, M., 1996 Bank Soundness and Macroeconomic Policy International Monetary Fund, Washington, DC.

Mandanis Schooner, H., Taylor M., 1999 Convergence and Competition: The Case of Bank Regulation in Britain and the United States Michigan Journal of International Law 20,

595, 601.

Slaughter, A.-M., 2004 A New World Order Princeton University Press, Princeton, New Jersey.

The Changing

Nature of Banks

Banks provide the lifeblood of a modern economy They take funds from firms and individuals with surplus savings and allocate them to other firms and individuals who need to borrow Other types of financial intermediaries also perform this eco-nomic function, but banks are distinguished by their promise to return savers’ funds

at any time, or on demand Before we examine the justification for bank regulation,

it is essential that we understand the nature of banks’ activities and why the

combi-nation of activities renders banks potentially special We will also look at the ways

in which the activities of banks have changed, often quite dramatically,

in the past two or three decades

a bank attempt to capture this aspect of their activities.

In 1899, the United States Supreme Court, in Auten v United States National

Bank of New York, considered the definition of a bank:

A bank … is an institution, usually incorporated with power to issue its issory notes intended to circulate as money (known as bank notes); or to receive the money of others on general deposit, to form a joint fund that shall

prom-be used by the institution, for its own prom-benefit, for one or more of the purposes

of making temporary loans and discounts; of dealing in notes, foreign and domestic bills of exchange, coin, bullion, credits, and the remission of money;

or with both these powers, and with the privileges, in addition to these basic powers, of receiving special deposits and making collections for the holders of negotiable paper, if the institution sees fit to engage in such business.2

No statute defined a bank in English law for a long period Common law courts developed various definitions The most prominent was the definition developed by

Diplock LJ in the 1966 case of United Dominions Trust v Kirkwood:

What I think is common to all modern definitions and essential to the carrying

on of the business of banking is that the banker should accept from his ers loans of money on deposit, that is to say, loans for an indefinite period upon running account, repayable as to the whole or any part thereof upon demand by the customer …3

custom-The concept of deposit-taking as the core activity of banks was subsequently incorporated in the first statutory definition in English law, in the Banking Act 1979, and has continued in its successor statutes For example, the Financial Services and

Markets Act 2000 in the United Kingdom provides that bank means a UK institution

1 A direct investment, as opposed to an intermediated investment, is one in which the provider of funds makes an investment directly, without a middleman.

2 Auten v United States National Bank of New York, 174 U.S 125, 141–42 (1899) The origin of the

statutory definition of the business of banking in the United States is discussed in detail in Chapter 7.

3 United Dominions Trust v Kirkwood (1966) 1 All English Reports, page 968.

which has permission under Part 4 of the Financial Services and Markets Act 2000

to carry on the regulated activity of accepting deposits

European Union law takes a more extensive view of the functions of a bank EU

law refers to a credit institution rather than a bank, and such an institution is

permit-ted to engage in a range of 14 activities specified in Annex I to the Credit Institutions Directive (2006/48/EC) The first two activities in the list of 14 are deposit taking and lending

EU law has been very influential in the banking statutes adopted by countries of the former Soviet Union and Eastern Europe, many of which have enacted these statutes only since the mid-1990s For example, the Republic of Armenia’s banking statutes provide a comprehensive list of bank activities, and the first two provide that “banks … may: a accept demand and term deposits; [and] b provide commer-cial and consumer credits…”4 In the Republic of Albania, bank activity is defined

as “the receipt of monetary deposits or other repayable funds from the public, and the grant of credits or the investment for its own account, as well as the issue of payments in the form of electronic money.”5

Japan’s Banking Act defines banking business as “any of the following acts: (i) Both acceptance of deposits or Installment Savings, and loans of funds or discounting

of bills and notes; or Conducting of exchange transactions.”6 In Qatar, the banking business is defined as “acceptance of deposits for use in banking operations, such as discounting, purchase or sale of negotiable instruments, granting loans, trading in foreign exchange and precious metals…”7 Australia’s Banking Act includes the fol-lowing definition of banking business: “both taking money on deposit (otherwise than

as part-payment for identified goods or services) and making advances of money.”8

From all these various definitions, some common themes emerge Banks take deposits and lend out depositors’ funds in the form of loans and advances This forms the traditional model of banking

Money, Credit Creation, and Fractional

Reserve Banking

While many other firms also serve as financial intermediaries (insurance companies, mutual funds), banks are a special type of financial intermediary because their liabili-ties (i.e., deposits) comprise a large part of the supply of money in a modern

4 Republic of Armenia Law on Banks and Banking Article 34(1).

5 Article 4(2) On Banks in the Republic of Albania.

6 Banking Act (Act No 59 of 1981).

7 Decree Law No 15 of the Year 1993 Establishing Qatar Central Bank.

8 Banking Act 1959.

economy We are often accustomed to think of money in terms of physical objects like metallic coins or paper notes In fact, however, deposits at banks form by far the greatest part of the total stock of money, and debts are settled and payments made by transfers between accounts held at banks.9

This was not always true Historically, payments evolved from a barter system

to one that replaced it with the exchange of precious metal coins Barter was

inef-ficient because it required what economists call a double coincidence of wants For

example, if a farmer has two bushels of wheat and wants to exchange them for a new pair of shoes, the farmer must find a shoemaker who wants exactly that amount

of wheat Currencies based on coins struck from precious metals avoided the need for this double coincidence of wants With the creation of currency, the shoemaker could take the farmer’s coins in exchange for his shoes and then use the coins to buy whatever he wanted Since not all metal coins were of equal value, a market for exchanging one type of metal coin against another developed The people who oper-ated this market and who calculated exchange rates between metal coins (much like the current exchange rate between the dollar and the euro or yen) were known as

money changers The word bank derives from the Italian banca, the word for the

wooden bench the money changers used to display their coins Since the money changers needed vaults and safes to store their precious coins and bullion, it was but

a short step to allow other merchants to use the same vault for the safekeeping of their coins and bullion

What began as a safe-keeping service for other merchants evolved over time into

a payments service Instead of transporting large quantities of precious metal from one town to another, bankers offered merchants the possibility of making payments with a bill of exchange, i.e., a document demanding payment, drawn on the hoard

of coins in their vaults The bill of exchange transferred the ownership of the cious coins from one merchant to another without any coins leaving the money changer’s safekeeping The bills of exchange began to circulate, transferred from one party to the next, and they were rarely presented to the money changer for final payment in gold In consequence, with the rise of banks in the late seventeenth and early eighteenth centuries, a new form of money began to emerge: paper money

pre-in the form of notes issued by banks By the mid-npre-ineteenth century pre-in England, paper money had become one of the main payment instruments in business transactions

9 Different countries use slightly different measures of the money supply, but they have a number of common features There is a narrow measure (often called M0) that relates to cash (coins and bank notes) and banks’ deposits with the central bank Several broader measures are also used, usually relating to deposits of different maturities For example, the European Central Bank refers to M1 as M0 plus over- night deposits; M2 as M1 + deposits with a maturity of up to two years; and M3 as M2 + shares in money market mutual funds.

In the course of time, checking accounts replaced bank notes Increasingly, checks became the payment instrument of choice, with payments between two parties involving a transfer across the ledger (balance sheet) of either a single bank or, if the parties held accounts at different banks, across the ledger (balance sheet) of a third bank at which both the other banks maintained accounts Party A merely issued an instruction to his bank to debit his account and to credit the account of party B Sophisticated clearing and payments systems have developed since, culminating in the demateralization of money in which payments increasingly take the form of electronic deductions direct from bank accounts (e.g., debit cards, Internet bill payment facilities, and the like).10 Note that banks remain essential to the payment system despite the demateralization of money, since virtually all modern payment mechanisms involve a credit and debit against deposit accounts held with a bank.The emergence of bank deposits as the main form of money transfer in modern financial systems is not surprising Bank deposits are a form of demandable debt, in

that the bank contracts to pay a fixed sum of money on demand of the customer

Demandable debt instruments possess many of the characteristics of a good medium

of exchange Their face value is easily ascertained; they are divisible; they can be structured so that ownership is easily transferable; and those who accept them have few worries about losses These factors make demandable debt a very good substi-tute for coins or paper money as a medium of exchange

A second special feature of the banking business also emerged from the business

of the money changers When notes issued by the money changers began to circulate freely, they quickly realized that the notes would rarely be presented for final settle-ment in precious metal This enabled the money changers to lend more money than they actually held in their vaults by issuing bank notes of a greater value For example, if the money changer had vault coins worth $100, he could issue bank notes worth, perhaps, $300 or $400, secure in the knowledge that the holders of the notes would rarely ask for payment in coin or bullion This allowed the money changers to create $300 or $400 out of only $100

Modern banks also create money To understand how, consider a country in which there is only one bank Customer A deposits $100 in cash with the bank Just like the money changers, the bank assumes that on any given day Customer A will likely withdraw only $10 of that deposit So, the bank is able to lend the remaining

$90 to Customer B Customer B deposits the proceeds of the loan, i.e., the $90, into the bank Again, the bank assumes that Customer B will likely withdraw only 10%

of the $90 deposit Therefore, the bank sets aside $9 in reserves and lends $81 to

10 Note that a credit card does not fit the definition because it does not involve a direct deduction against

a bank account A credit card is simply a short-term unsecured loan Only when the customer uses an internet payment facility to pay off the account balance, or to make a payment on the account, does the principle indicated here apply.

Customer C This process can continue until the original $100 cash deposit will serve as the basis for $900 in loans.

Banks operate on the basis of fractional reserves described here Banks hold, in the form of reserves, only a fraction of the deposits that they receive from their customers Banks are able to maintain fractional reserves as long as depositors’ withdrawals (their demand for liquidity) are stable and predictable Banks need not keep piles of cash in their vaults equal to their total deposits because not all deposi-tors will withdraw the full amount of their deposits on the same day So, the bank that received the cash deposit of $100 knows from past experience that the depositor

is likely to demand a cash withdrawal of only $10 on any given day This knowledge enables the bank to operate with a fractional reserve of 10% The lower the fractional reserve, the greater the bank’s ability to lend more money (consider the impact if a bank decided it could operate with a 5% reserve instead of one of 10%)

Central banks emerged out of fractional reserve banking Central banks served

as the banks’ bank, acting as custodian for the reserves of other banks Initially, the banks that acted as custodians for the other banks’ reserves were commercial banks that were regarded by other banks as being particularly sound and low risk The Bank of England, for example, began as a commercial bank but evolved into the custodian of the English banking system’s reserves owing to its reputation for pru-dence and its implicit support from the government Over time, the banks that held the banking system’s reserves ceased to perform any commercial activities of their own, and other banks became their only clients This was the pattern followed by the earliest central banks, such as the Swedish Riksbank (the oldest central bank in the world), the Bank of England, and the Banque de France In countries in which one commercial bank did not naturally evolve into a central bank, they were estab-lished under statute, as was the case with the Federal Reserve (1913) Many central

banks established in this way are still known as reserve banks (for example, the

Reserve Bank of Australia or the South African Reserve Bank) Central banks assumed responsibility for controlling the growth of money and credit in the economy and, thus, the rate of inflation

In the modern financial system, central banks operate through three main etary policy tools: reserve requirements, open market operations, and the discount rate

mon-Depository institutions are required, by statute or by the central bank, to maintain

a fraction of certain liabilities (usually certain categories of deposit) in reserve in specified assets (usually deposits) with the central bank These are required reserves The central bank can adjust reserve requirements by changing reserve ratios, the liabilities to which the ratios apply, or both In countries where the banking system relies heavily on deposits for its funding, changes in reserve requirements can have profound effects on the money stock and on the cost to banks of extending credit through the multiplier process we described previously

Historically, reserve requirements served as the main instrument of monetary policy In recent decades, reserve requirements have fallen out of favor in many advanced economies, although they are still widely used in the emerging markets

As discussed later in this chapter, banks no longer rely as heavily on deposits as a source of funding their operations Thus, the shift toward a market-based system of finance undermined the effectiveness of required reserves as a monetary policy tool.Open market operations are the central bank’s purchase or sale of bonds in the open market When the central bank purchases securities through government securi-ties dealers, the account balances of the dealers are credited with this amount Thus, the total amount of funds at the dealer’s banks increases by the value of securities purchased by the central bank This will permit an increase in the money supply

An open market purchase leads to an increase of deposits in commercial banks’ accounts and hence to a growth of the money supply or the monetary base By contrast, an open market sale leads to a reduction of deposits and reserves in commercial banks’ accounts and hence a decline in the money supply Changes in the money supply influence short-term money market interest rates (known as the Fed Funds Rate in the United States or LIBOR—the London Interbank Offered Rate—in Britain), which are the rates that banks charge each other for overnight loans of the reserves they hold at the central bank This short-term interbank rate is

a market-determined rate, but since the central bank can control the supply of bank reserves through its open market operations, it plays a major role in influencing the overnight rate The central bank will also allow banks to borrow from it directly at

a rate substantially above the market-determined overnight rate This lending facility

is often referred to as the discount window and hence the rate at which the central bank lends is the discount rate Discount window lending, which is available to help

banks in need of overnight liquidity, differs from the lender of last resort function that we discuss in Chapter 4, which involves the central bank lending to an illiquid but solvent bank

Financial Innovation and the Changing

Nature of Banks

So far, our account of the nature of banks reflects the traditional model under which banks funded their operations primarily through deposits (i.e., funds placed with them by large numbers of individuals), and their operations were centered on making loans Within the past 30 years, however, deregulation has fundamentally trans-formed the nature of the banking business As a result, the current business of banking differs greatly from the traditional model that prevailed up until the 1970s The moniker for the traditional model is 3–6–3: bankers took deposits at 3%, lent

at 6%, and were on the golf course by 3 p.m

the World of 3–6–3 BankIng

In the financial system that operated from the end of World War II until the 1980s, banks rarely engaged in cross-border operations for the simple reason that curren-cies were not freely convertible Under the so-called Bretton Woods11 system, all other currencies were pegged to the U.S dollar at a fixed rate, while the dollar itself was pegged to gold at a fixed price of $32 per ounce.12 An extensive system

of exchange controls held this system in place: in most countries foreign currency could be obtained only for certain specified purposes—e.g., to allow an importer

to pay for a specific shipment of goods—and sales of a nation’s currency to eigners were strictly regulated, as was the import and export of gold Inevitably, given these constraints, banks operated mainly within the borders of the countries that licensed them, and extensive overseas operations were unusual Banks operat-ing on a cross-border basis were comparatively rare and tended, where they existed, to be the remnants of vanished empires

for-Within the borders of each nation, banking was tightly regulated One of the main

tools of bank regulation at this time was required reserves known as the reserve

ratio or cash ratio As discussed previously, required reserves are a tool of monetary

policy, but required reserves also served a regulatory function Required reserves regulate a bank’s activities in that they restrict the bank’s use of the funds on reserve and thus its ability to grant new loans (reserves cannot be lent to the bank’s custom-ers) Most countries’ governments actively discouraged competition in banking Many regulated by statute the interest rate that banks could charge to their borrowers

or pay to their depositors Governments valued stability above competitive efficiency and aimed to protect banks from the risk of failure through ensuring that they were always sufficiently profitable—earning a sufficiently wide spread between their deposit and lending rates—that their financial soundness would never become a problem In European countries many banks were owned by the state

The business of banking at this time was still comparatively simple and remained much as it had been for over a century Banks took deposits and made loans Large industrial corporations raised most of their funding needs from bank loans rather

than from the capital markets Specialized types of banks, known as savings and

loans in the United States and building societies in the United Kingdom, financed

11 This system was named for the New Hampshire resort that had hosted an international monetary ence in 1944, just as World War II was drawing to a close.

confer-12 Bretton Woods replaced the pre-War Gold Standard in which all currencies were pegged to gold, at the time the international medium of exchange Under the Gold Standard, all international payments had

to be made in gold, but there was simply not enough gold to go around This meant that international trade had been severely constrained, and it in turn contributed to the severity of the Great Depression.

home purchases Typically, such specialized banks were not corporations owned by shareholders but were mutuals, owned by their depositors.

Banking was also strictly segregated from other forms of financial activity In the United States, the 1933 Banking Act, popularly known as the Glass-Steagall Act, separated commercial banking from investment banking Other countries had similar legislation, such as Article 65 of the Japanese Securities Law Even where such legislation did not exist, as in Britain, banking was kept separate from securities business by a network of unwritten norms Insurance was also kept separate from either of banking or securities underwriting and trading Thus, the financial services industry was separated (either by law or custom) into three distinct sectors: com-mercial banking, investment banking, and insurance

This highly regulated system was extraordinarily stable Whereas between 1929 and 1933, more than 9,000 banks ceased operations in the United States, between

1945 and 1975 bank failures were rare Only 123 institutions failed in that 30-year period

Changes began in the 1970s, especially after the collapse of the Bretton Woods system of exchange rates in 1973 Currencies were allowed to float freely against one another with their value determined by the market forces of supply and demand Exchange controls were also dismantled over a period of years, leaving capital free

to flow to the highest returns In the countries of (what is now) the European Union, this process was accelerated by the desire to establish an integrated Single Market, including in financial services Banking and financial systems that had been pre-dominantly nationally based now became the facilitators of these international capital flows Cross-border banking became a reality

Free capital flows were accompanied by other measures to deregulate the economy The election of Margaret Thatcher as Prime Minister of Great Britain in

1979, followed by that of Ronald Reagan as President of the United States a year later, heralded a sea change in thinking about the relationship between the state and the market The 1970s had been a decade of relative stagnation throughout most of the industrialized economies, and many blamed excessive levels of government regulation The free market revolution that was ushered in during the 1980s deregu-lated whole swathes of the economy and led to a wave of privatizations in which many state-owned companies—including banks and other financial institutions—were sold to private investors

The deregulation of banking and finance was a core component of the free market policies pursued in the 1980s For the benefits of deregulation in other economic sectors to be realized, it was argued, it was necessary for capital and credit to be allocated to those who could use it most efficiently To ensure this outcome, financial institutions should respond to the market in allocating credit Interest rate controls and ceilings were abolished, and central banks ceased trying to control the growth

of credit directly through adjusting the reserve ratio on deposits The restrictions on

banks owning nonbank financial institutions and vice versa were gradually removed The culmination of this process was reached in the United States with the passage

of the Gramm-Leach-Bliley Act in 1999, which, among other things, removed the Depression Era separation of commercial from investment banking

the emergence of a neW BankIng system

The new banking system that has emerged in the past three decades has several features that distinguish it from the traditional model of 3–6–3 banking:

Banks began to operate on a cross-border basis on a huge scale Data from the Bank for International Settlements, which has monitored these trends for many decades, show consolidated international bank claims rose from $703 billion in 1983 to

a staggering $20 trillion in 2008 Developments in the banking market were mirrored by trends in other sectors of the financial industry

Banks were no longer constrained by geography Not only did deregulation and the free flow of capital allow massive extension of their cross-border business, but developments in information and communications technology now allowed a central head office to manage vast, geographically far-flung businesses

The banking sector underwent a wave of consolidation In the globalized ment size can provide advantages A study of bank concentration in the 1990s found that the “number of banking firms in each country tended to decrease during the decade and the concentration of the banking industry, as measured by the percentage of a country’s deposits controlled by the largest banks, tended to increase.” (Group of Ten, 2001, p 11) The concentration trend has continued in more recent years (Davis, 2007)

environ-Banks no longer concentrated exclusively on banking They began to earn more

of their income from fee-based services, such as providing financial advice or arranging large syndicated loans (i.e., loans in which a number of banks each agree to take a share) Financial groups also diversified away from traditional banking into securities underwriting and trading and insurance The growth of

these financial conglomerate groups also contributed to the trend toward

large-scale financial businesses

Markets began to play a much bigger role in the financial system One aspect of marketization was the increasing tendency for the biggest corporations to raise capital directly from the capital markets—for example, by issuing bonds rather

than borrowing from banks This phenomenon became known as

disintermedia-tion as banks ceased to act as intermediaries between borrowers and the ers of capital Nonetheless, although they became less important as providers of capital and credit, the banks remained involved in the process as underwriters

provid-of bond issues (they agreed, in other words, to act as buyer provid-of last resort in the

event that their client could not find a sufficient number of buyers for its bonds)

In addition, an increasing share of banks’ profits came from their active trading

in the financial markets, operations in which they were not buying and selling on behalf of clients, but on their own account with a view to making a profit from price movements

Deregulation unleashed a wave of innovation in new financial products, many of which were developed in response to the new era of volatility that followed deregulation Volatility was first evident as currencies began to change their rela-tive values by multiples of the movements that had been permitted under Bretton Woods Soon interest rates and stock and commodities markets also became more volatile Volatility created demand for products to manage the resultant risk, and the first financial derivatives contracts began to trade on the Chicago Mercantile Exchange in 1972 These were rapidly followed by other instruments, such as commodity options (permitted in 1976) and futures on the S&P 500 (1982) Increasingly, derivatives contracts began to trade bilaterally between banks rather

than on an organized exchange This became known as the over-the-counter

(OTC) market, which soon accounted for the overwhelming value of interest rate, exchange rate, and other instruments traded

Three Distinctive Features of Modern Banking

Although there are many differences between the modern banking system and the traditional 3–6–3 model, three in particular stand out: greater reliance on wholesale money markets for funding; securitization, which permitted banks to change the composition of their asset portfolios (and their risk profiles); and the emergence of

a new model of banking known as originate-to-distribute.

relIance on money market fundIng

In the traditional model, banks’ lending was constrained by their ability to attract deposits The advantage of relying on deposits is that they tend to be relatively stable

In particular, retail (i.e., smaller-scale) depositors, experience shows, are usually the

last to engage in bank “runs,” perhaps because they are the least well informed about the condition of banks

The conventional way to evaluate a bank’s reliance on deposits for its funding is

through a measure known as the loan/deposit ratio This ratio expresses the total

value of loans in terms of the total value of a bank’s deposits A loan/deposit ratio

of 1 means that a bank lends out all the deposits that it takes in If the loan/deposit ratio is less than 1, say 0.8, it means that the bank is taking in more deposits than

it is lending out, with the difference accounted for by investments in safe and liquid assets like government securities Traditionally, in the world of 3–6–3 banking, most banks operated on a loan/deposit ratio of less than 1, with up to 30% of their assets comprising government securities This was widely viewed as a safe and prudent way to manage a bank.

In recent decades, however, banks in the advanced economies have begun to operate on loan/deposit ratios of greater than 1 How is this possible? Banks have taken advantage of sources of funding other than traditional deposits For example,

banks borrow funds in the money market from other financial institutions, large

nonfinancial corporations, state and local governments, and even from foreign ties With the emergence of money market mutual funds (MMMFs) in the 1980s as

enti-a menti-ajor riventi-al to trenti-aditionenti-al benti-ank deposits, benti-anks increenti-asingly funded themselves by borrowing funds placed into the money markets by these mutual funds Banks issued debt in the form of instruments like certificates of deposit (CDs) and short-term commercial paper, which were purchased by MMMFs or by the treasuries of large

nonbank corporations These forms of funding are referred to collectively as

These wholesale sources provided flexible funding and rendered central banks’ traditional approach to monetary control through varying levels of required reserves anachronistic Instead of engaging, for example, in a retail marketing campaign to attract new deposits, banks could raise funds quickly and easily by issuing com-mercial paper or CDs Great flexibility in funding allowed banks to exploit new investment opportunities and, arguably, reduced their liquidity risks A bank that found itself short of funds could tap the money market, making the banking system less vulnerable to the risk of a rapid withdrawal of deposits Some academics argued that greater reliance on money market funding also increased the market discipline

of banks Unlike retail depositors who tend to be relatively uninformed about the riskiness of a bank’s business and who lack the incentives to monitor banks closely (see Chapter 2), corporate treasurers and the treasurers of MMMFs possess both the knowledge and expertise to monitor closely the banks to which they lend

Unfortunately, however, evidence suggests that the reliance on wholesale funding introduces new risks The past 20 or 30 years has shown that banks which rely on wholesale markets can be vulnerable to sudden losses of funds and subsequent insolvency We will come across examples of these problems in future chapters: they include Continental Illinois in the U.S and Northern Rock in the U.K

(see Chapter 11) Wholesale markets tend to be less stable sources of funding than traditional deposits, as banks learned during the Global Financial Crisis Banks that had assumed the ready availability of wholesale funding discovered that all other banks had made the same assumption As a result, toward the end of 2007, when banks around the world looked to wholesale markets to fund their shortage in liquid-ity, they had difficulty accessing the funds they required.

system as market-centered in contrast to the bank-centered systems of Europe and

Asia.13 Nonetheless, the trend toward securitization was also apparent internationally

as net bond and commercial paper financing caught up with and then overtook international bank lending in the late 1990s

Mortgage finance is one area of financial activity in which the securitization trend had a particularly strong impact For the first three decades of the post-war world, the mortgage business was dominated by savings and loan institutions (in the United States) or building societies (in Britain) The funding for those loans came from the passbook savings of the customers of the S&L or building society, while the loan itself would be held on the lender’s balance sheet until maturity or repayment However, during the 1980s, regulatory change and the near collapse of the S&L industry in the United States opened the mortgage market to a much wider range of financial institutions At the same time, mortgage loans no longer remained as assets of the financial institutions that originated the loan Instead, mortgages were often repackaged into pools of debt (in other words, securitized), which were then marketed and remarketed in the form of shares or bonds The key institutions in this process in the United States were government-sponsored

13 In a bank-centered financial system (Germany is the typical example), firms rely primarily on bank loans as the source of funding for their operations In contrast, in a market-centered financial system, firms rely more heavily on securities markets as the source of funding for their operations (e.g., by selling stock in the firm to investors who thereby provide equity capital).