Figure 2 «The End of Bonking As We Know It?»

Panel A. What the End of Banking Could Do

• Weaken the Fed's ability to influence the economy through monetary policy • Increase the size and complexity of risks the Fed must get under control in a financial crisis • Hurt small and medium-sized businesses that depend primarily on banks for loans and financial advice • Reduce access to traditional banking offices by spurring consolidation among the nation's numerous commercial hanks • Because of the outflow of assets and deposits from the banking system, pose a wider range of risks associated with the $7 trillion market in financial derivatives, i.e., new financial products (futures, options, and swaps) that link banks, investment firms. and corporations in efforts to hedge against changes in interest rates, stock prices, commodity prices, and currencies

Panel B. Some Thoughts by Banking Experts

Alan Greenspan, chairman of the Feel «Public policy should be concerned with the decline in the importance of banking. The issues are too important for the future growth of the economy and the welfare of our citizens». Eugene Ludwig, comptroller of the currency «I think that banks play a fundamentally important role in society that is less well filled by others. l see a decline in the banking system as a shifting of risk-rather than an elimination of risk-to the public from the government». Edward Crutchfield, chairman, First Union «We'll live or die on our customer service». William Issac, former chairman FDIC «The banking industry is becoming irrelevant economically, and it's almost irrelevant Politically». Andrew Hove, former chairman FDIC «Will banks be able to attract the money back as loan demand increases? I think they will, but you wonder». Economic Policy Institute (a liberal think tank) Solution: Impose bank-type regulation over the «parallel» financial system of nonbank financial-services firms that perform bank functions.

The role of bank regulation and supervision

Because commercial banks are more heavily regulated than their nonbank competitors, many bankers view the playing field as slanted in favor of the competition. To evaluate this charge, let's consider the role and degree of bank regulation and supervision in the United States. In 1984 a former U.S. bank regulator proposed the following strength-in-banking equation:

New Powers + Firm Supervision → Strength in banking (1-1)

This framework can be applied to either established financial systems or developing ones. In general, the trade-off in equation (1-1) is a direct one. The more powers and freedom banks are given, the greater is the need for firm supervision (e.g . monitoring and risk-based pricing) if strength in banking is to be maintained. The supervision can originate from financial markets or regulators or both (i.e., market versus regulatory discipline). Regarding market discipline, the chief executive officer of a major U.S. banking company recently stated: «We believe financial institutions should be operated as if there were no regulators for supervision, no discount window for liquidity, and no deposit insurance for bailouts». This view means that bank managers take seriously their fiduciary responsibilities to their depositors and other creditors. For this approach to work, market participants must penalize bank managers who violate that trust (e.g., by engaging in unexpected risk taking).

The Principal-Agent Relations in a Regulated Financial System

In a regulated environment, a government guarantee (in the form of deposit insurance) may give depositors confidence in banks, but at the same time it may cause banks to shirk their responsibilities-a moral-hazard problem. Moral hazard refers to behavior that is altered by the existence of insurance (e.g., greater risk taking by insured depositories). Table 1-7 depicts the principal-agent relations in a regulated financial system. If the government guarantee is credible and protects all bank debt, market discipline may fail to exist. In this case, regulatory discipline must prevent excessive risk taking by monitoring bank behavior. In a regulated banking system, market and regulatory discipline should complement each other.

Techniques for Managing the Guarantee Business

Since bank regulators and supervisors supply guarantees (either explicit or implicit) that banks are safe and sound, they can be viewed as operating a guarantee business. Merton and Bodie [1992] describe three interrelated methods available to a guarantor (e.g., bank regulator or deposit insurer) to manage its business:

• Monitoring the value of the collateral

• Restricting the kinds of assets acceptable as collateral

• Charging risk-based premiums

In practice, bank regulators use combinations of monitoring, asset restrictions, and risk-based pricing to manage their guarantees (i.e., to achieve firm supervision). Some of the specific weapons that bank regulators and deposit insurers use to promote safe-and-sound banking include on- and off-site bank examinations, risk-based capital requirements, risk-based deposit-insurance premiums, cease-and-desist orders, removal of bank officers and directors, prompt corrective action, and CAMEL ratings (C = capital adequacy, A = asset quality, M = management, E = earnings, and L = liquidity), These weapons provide the ingredients for the firm supervision component of the strength-in-banking equation.