INT’L FINANCIAL SYSTEM JOINT CLASS TEN FINANCIAL INTERMEDIATION AND REGULATION

1. INT’L FINANCIAL SYSTEM JOINT CLASS TENFINANCIAL INTERMEDIATIONAND REGULATION Prof. David K. Linnan UI-UGM-USC-UNDIP-USUUniv. of South Carolina Joint Videoconferenced ClassSchool of Law October 17, 2002

2. BANK VS. CAPITAL MARKET What 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

3. BANK VS. CAPITAL MARKET Re 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)

4. BANK VS. CAPITAL MARKET Bank-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)

5. BANK VS. CAPITAL MARKET Bank-Based Financial Intermediation View 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)

6. BANK VS. CAPITAL MARKET Bank-Based Financial Intermediation View 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)

7. BANK VS. CAPITAL MARKET Capital 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)

8. BANK VS. CAPITAL MARKET Capital Market-Based Financial Intermediation View 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

9. BANK VS. CAPITAL MARKET Capital Market-Based Financial Intermediation View 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)

10. BANK VS. CAPITAL MARKET BANKS 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

11. FINANCIAL INTERMEDIATION All 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)

12. FINANCIAL INTERMEDIATION FUNCTIONAL 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)

13. FINANCIAL INTERMEDIATION FUNCTIONAL 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

14. FINANCIAL INTERMEDIATION Banking 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

15. FINANCIAL INTERMEDIATION FINANCIAL 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 mastercard to 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.

16. FINANCIAL INTERMEDIATION The 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 protection 2. Systemic risk 3. Moral hazard if external guarantees (government deposit insurance domestically, IMF bailout internationally)

17. FINANCIAL INTERMEDIATION COMPARE (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 ____

18. FINANCIAL INTERMEDIARIES THE 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?

19. FINANCIAL INTERMEDIARIES THE 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 mastercard to 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)

20. FINANCIAL INTERMEDIATION DERIVATIVES 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

21. BASEL STANDARDS LOOK 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?

22. US BANKING REG HISTORY HOW WE GOT HERE National Bank Act of 1864 Pre-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

23. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) Federal Reserve Act of 1913 Created Federal Reserve as central bank plus gave prominent role in banking supervision

24. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) Edge Act of 1919 International banking authorization for banks to create special purpose subs (so Citi is not new phenomenon)

25. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) McFadden Act of 1927 Established dominance of state banking laws to determine interstate banking structures, essentially prohibiting interstate branching in theory to preserve community banking

26. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) Banking Acts of 1933 & 1935 As response to 1930s banking crisis, • separate commercial from investment banking (so commercial banks could not be universal banks in European model, investment banking being core capital markets activity), • established interest ceilings on deposits, • established FDIC as insuror with regulatory powers, • restricted bank activities particularly interlocking directorates and insider lending, • generally broadened supervisory powers

27. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) Federal Home Loan Bank Act of 1932 and Federal Credit Union Act of 1934 Established parallel institutions with special housing & mutual markets covered also by insurance, with own parallel regulatory structure

28. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) 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

29. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) Savings & Loan Holding Company Act of 1967 Parallel S & L regulation like BHCA, but under FHLBB

30. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) Depository Institutions Deregulation & Monetary Control Act of 1980 • First big deregulatory financial sector statute, • phasing out deposit interest rate ceilings, • Expansion of permissible S & L activtties • 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

31. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) 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

32. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) 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.)

33. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) 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

34. US BANKING REG HISTORY HOW 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)

35. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) 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.

36. US BANKING REG HISTORY HOW WE GOT HERE (Cont’d) 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.

37. 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?