External conditions: the risks of price-level and sectoral instabilities

Character, capacity (cash flow), capital (net worth), collateral, and conditions (economic) capture the five Cs of credit analysis. Although economic conditions play a crucial role in the safety and soundness of financial institutions, banks have no direct control over this factor (e.g., deflation has been especially harmful in disrupting borrowers' abilities to repay loans). To illustrate the importance of economic conditions, consider the following counterfactual propositions for the U.S. economy: a level of price stability that avoided the interest-rate spikes of 1966, 1969-1970, 1974, and 1980-1982 and absence of sectoral deflations in energy, farm and commercial real estate. Under this scenario, without the international debt crisis the bank and thrift problems of the 1980s and early 1990s would have been substantially reduced, if not eliminated.

This fictional talc highlights the connection between the behavior of monetary policy and the conditions under which borrowers and lenders contract. The essence of the connection is the uncertainty associated with future interest rates and prices. Clearly, reducing this uncertainty would increase financial stability. Absent such monetary reform, lenders must price credit and interest-rate risks carefully, diversify, and be liquid.

Problem banks: identification, enforcement, and closure

The bank regulator's supervision problem can be viewed in terms of identification and enforcement. The critical issue in the United States in the 1980s and early 1990s has been the lack of an effective bank closure rule-an enforcement problem. Because most closed banks in the United States were identified prior to closure as problem banks, identification of problem institutions has not been the culprit. Nevertheless, without an accounting system to capture the economic value of banks' on- and off-balance-sheet activities, an effective closure rule will be difficult to implement. Although the "prompt-corrective-action" mandate of the FDIC Improvement Act (1991) attempts to remedy this deficiency, it also gives regulators considerable flexibility in designing the enforcement rules and action. Based on past experience, this may mean business as usual and ineffective regulatory discipline. On balance, however, the cumulative effects of explicit risk-based pricing of deposit insurance (1993), more refined risk-based capital requirements, and FDlCIA may be enough to overcome the shortcomings of the past.

Recapitulation and lessons

Credit risk and interest-rate risk are the critical risks faced by depository institutions. Securitization enables banks to remove risks from their balance sheets, but it simultaneously erodes their traditional business of funding loans with deposits. Although the mismanagement of credit and interest-rate risks has been the leading cause of U.S. bank and thrift failures, a mismanaged system of regulation and deposit insurance and the interest-rate and price volatilities of the years 1966 to the early 1990s are intricately interwoven in the fabric of the U.S. bank and thrift crises. To attempt to avoid the problems that has plagued the U.S. banking system, developed and developing countries need to maintain a stable economic and financial environment, to regulate banks in a way that does not restrict their diversification opportunities, and if they provide deposit insurance, to price it properly (e.g., on the basis of risk exposure ).

THE DIMENSIONS OF FINANCIAL-SERVICES COMPETITION AND THE ROLE OF REGULATION IN SHAPING THEM

Financial-services firms and their regulators compete for business in three basic areas: explicit price, user convenience, and public confidence. As regulated firms, banks typically have faced restrictions with respect to price, place, and product, among other things. These restrictions limit the ability of regulated FSFs to compete, and they fundamentally shape all aspects of the financial-services business, but especially the price, convenience, and confidence functions.

The Price Function

Interest rates on loans and deposits (and prices for other financial services) are the explicit prices of banking. Government-imposed ceilings on bank interest rates, if effective, restrict competition and result in market distortions. In 1933, the U.S. government imposed deposit-rate ceilings on banks and prohibited payment of interest on demand deposits (checking accounts). For years the ceilings were not binding, because market interest rates remained low. However, when the U.S. economy began facing a series of increasingly severe interest-rate spikes, beginning in 1966 and peaking in 1980-1982, the costs and distortions of the ceilings began to take a heavy toll in terms of disintermediation and discrimination against small savers. The current regulatory environment permits banks to compete more freely for loans and deposits on the basis of interest rate-the price dimension. On balance, the techniques of monitoring, asset restrictions, and risk-based pricing are more efficient tools for attempting to limit bank risk taking than interest-rate controls.