“The Future of Regulation and Supervision of Financial Intermediaries”

 

 Continuous improvement in the efficiency with which we convert savings into investment is the pre-eminent objective that we, as a society, have for our financial intermediaries.  We want both to minimize the potential loss of savings, to individuals and society, and to maximize real, risk-adjusted returns on investment.  For the last century and a half, we have sought to minimize the potential loss of savings by accepting a role for the federal government in promoting what in the late 19th century would have been called “monetary stability” but by the late 20th century we came to call “financial stability.”

 

 In the last twenty years we have begun to strip away the obsolete segmentation that the federal government imposed on our financial system to shore up the soundness of financial intermediaries.  That compartmentalized regulatory scheme imposed too great a constraint on the efficiency of intermediation.  We have begun to dismantle these rigid functional and geographic barriers but we have not yet fully accepted the regulatory and supervisory consequences of our loss of faith in the efficacy of those barriers. 

 

 We need now to follow through on the Congress’ commitment to open up our financial services industry by focusing our regulatory efforts on promoting competition among all intermediaries.  We are still concerned for financial stability, but in a more competitive, more dynamic financial system, we must pursue this in a different way.  Supervisors of financial intermediaries need to be a little less concerned with preventing every bad outcome among their charges and, instead, should concentrate on improving the overall resilience of the financial system by thinking of it as a system.  In the language of statistics, distributions and portfolio theory, supervisors should minimize “negative tail” outcomes by striving to maximize “positive tail” outcomes. 

Adam Smith praised the invisible hand of individual incentive.  But he was even more passionate in his animus toward the visible hand of government.  His hostility was not to the exercise of government power per se but, rather, to its likely abuse by men of commerce – particularly the intermediaries or “dealers” – seeking to limit their competition or to gain privilege. 

 

 “The interest of the dealers,” Smith wrote, “is always in some respect different from, and even opposite to, that of the public.  To widen the market and to narrow the competition, is always in the interest of the dealers.  To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they would naturally be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens.  The proposal of any new law or regulation of commerce which comes from this order ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention.”*

 

 Adam Smith’s concern was mercantilism.  Today, however, he would recognize the competition-distorting consequences of all manner of subsidy, preference, and guarantee, as well as the problems of agency capture and regulatory arbitrage.  Moreover, for most of the last two centuries in banking and finance we tended to compound the general problem of competition-distorting government interventions by the very means we used to protect the stability of financial intermediaries. 

 

 Through the sovereign’s power to charter, we carved up the pathways of financial intermediation, allocating different sets of risks and returns as franchises for different forms of intermediation: deposit taking and loan making, investment underwriting, insurance underwriting, broking, and so forth.  Holding less than the total set of available risks and returns from financial intermediation, any one form is necessarily less robust, less stable, than the full set.  By itself, each one is prone to crisis in the event that its particular form of arbitrage suffers an abrupt or prolonged period of below average returns. 

 

 Each chartering authority reasonably sees its mission, however, as preserving the safety and soundness of its particular set of charges.  To counterbalance their vulnerability to crisis, the chartering authority is tempted to pad the revenues of its franchisees by limiting the competition they face or by providing special privileges not available to competitors.  These added returns, however, do not promote the efficiency with which society converts savings into investment; they represent only a toll – Adam Smith’s “absurd tax.”  Nor are the returns so extracted from our savings likely to make that particular form of intermediation any more robust in the long run.

 

We Americans made matters even worse with the misguided thought, reflected in Glass-Steagall, that the set of risks and returns called “commercial banking” could be made stronger by a rigid separation from the rest of the intermediation pathways and especially from the set of risks and returns called “investment banking”.  In the late 1980s starting with the regulatory reforms of the Federal Reserve Board, and eventually with the passage of the Gramm-Leach-Bliley Act in 1999, we began deconstructing the forced compartmentalization of our financial services industry.

 

 We need to see this process through by clearing out the cobwebs of regulatory arbitrage that restrict which firms can provide which financial services.  We have – and want to retain – different forms of financial intermediation.  But we also want to encourage vigorous competition at the frontiers among these forms and the firms that provide them.  Our system of financial rule writing – and particularly the licensing and chartering of financial services providers – needs to respect this dialectic: promoting alternative forms of intermediation and vigorous competition among them.  Limitations on who can compete, and on how they can compete, should be viewed with “the most suspicious attention.” 

 

 In a more competitive, more rough-and-tumble, financial environment, we may have more, not less, concern for financial stability – for minimizing the potential loss of savings for individuals and society. 

 

 The supervision of financial intermediaries – the hands-on job of looking over the shoulders of individual financial institutions – originates with the desire to avoid some set of bad outcomes: bank failures, depositor losses, fraud or some other form of consumer or social loss.  The supervisory challenge is to limit these negative tail outcomes.  To do so while still promoting competition and efficiency, however, requires that we recognize that individual failures are part of an overall system that produces both negative and positive outcomes. 

 

 When we adopt this portfolio viewpoint, we see that society as a whole is likely to benefit the most through the improvement of overall performance.  We can do that best when we strive to maximize positive tail outcomes across the whole financial system.  Snuffing out every bad outcome – that is, stifling competition – cannot be the way to spur the whole system to best performance.  Indeed, at both the broad level of systemic stability and for any particular products or sales practices, the only compelling case for financial supervision is as a means of more rapidly disseminating best practice than would otherwise be the case, in order both to minimize the likelihood of bad outcomes and to improve median and mode outcomes for society.

 

 There are two consequences of thinking of financial supervision in these terms.

 

 First, when we think of financial supervision in the context of the range of positive and negative outcomes that a particular form of financial intermediation produces, we better understand the systemic role of the supervisor.  Over the extended time horizon and the total portfolio of intermediaries of concern to the supervisor, minimizing the loss of savings will be a consequence of, not at odds with, the striving for the positive tail outcomes that reflect convergence on best practice and serve to maximize real, risk-adjusted returns. 

 

 Second, in order to be an effective means of redistributing best practice, the supervisor needs to know what best practice is.  This requires real knowledge and expertise about the risks and rewards of the particular businesses to be supervised.  In the absence of this knowledge and expertise, the supervisor is unlikely to be able to promote best practice and is more likely only to add to the cost of financial intermediation and, thereby, regrettably diminish the overall efficiency with which our savings are converted into investment.  At the practical level, in order to know best practice supervisors need to  be specialized by lines of business and sets of risks.

 

 If we can focus the role of the federal government on the twin tasks of expanding competition among the providers of financial services and of channeling supervisory resources to serve as a means of redistributing best practices, we will be moving in the right direction.